What is the Average Daily Balance Method?

The Average Daily Balance Method is a widely used approach by credit card issuers to calculate the interest charges applicable to cardholders. It hinges on the outstanding balances of the card for each day throughout the billing cycle.

Key Takeaways:

• The Average Daily Balance Method is a prevalent method for determining credit card interest charges.
• It is based on the card’s outstanding balances for each day of the billing period.
• The average daily balance is multiplied by the card’s daily periodic rate and the number of days in the billing period.
• The daily periodic rate is derived from the card’s Annual Percentage Rate (APR) divided by 365 (or 366 in a leap year).

Understanding the Average Daily Balance Method

The federal Truth-In-Lending Act (TILA) mandates credit card issuers to divulge their methodology for computing finance charges, Annual Percentage Rate (APR), fees, and other pertinent terms in their terms and conditions statement. This disclosure facilitates consumers in making informed comparisons among different credit cards.

To calculate finance charges, card issuers have several methods at their disposal. Among these are:

• Average daily balance method: The most common method presently used, calculating finance charges based on the balance at the end of each day in the preceding billing cycle.
• Previous balance method: This method computes interest charges on the amount owed at the commencement, rather than the conclusion, of the latest billing cycle.
• Adjusted balance method: This mode calculates finance charges on the balance at the end of the prior billing period minus any credits and payments made in the current period. New purchases are not factored in until the subsequent billing statement. Of these techniques, this one is the least prevalent.

If you settle your credit card balance in full monthly, you can avoid paying interest.

How the Average Daily Balance Method Works

The Average Daily Balance Method can manifest in various forms, with or without compounding in calculations.

In both scenarios, the formula equates to:

Average daily balance x daily periodic rate x number of days in the billing cycle = interest charge for that month

The methodologies involving and excluding compounding vary in their definitions of “daily balance.”

In the compounding Average Daily Balance Method, the issuer considers the balance at the commencement of each day, adds any new charges for that day plus any interest charges on the prior day’s balance, and deducts any payments or credits made on that day.

The issuer then accumulates all daily balances and divides this total by the number of days in the billing cycle to yield the average daily balance.

Applying the aforementioned formula, the average daily balance is then multiplied by the daily periodic rate (the APR divided by the days in a year) and lastly by the days in the billing cycle. This outcome represents the interest charge by the card issuer for that month.

The Average Daily Balance Method devoid of compounding operates similarly with the exception that the card issuer does not factor the previous day’s interest in ascertaining the daily balances. Consequently, compounding of interest does not occur, as seen with the other method.

The compounding method proves costlier for cardholders and more advantageous for card issuers compared to the non-compounding approach.

Additional variations of the Average Daily Balance Method include including new purchases and excluding new purchases. The former mirrors the previously described method, while the latter refrains from considering purchases made during that billing period until the subsequent one.

Average Daily Balance Method Example

Here is a simplified illustration of the Average Daily Balance Method without compounding.

Let’s assume a credit card has a $1,000 balance at the start of the billing period and an APR of 20% (or 0.20). This APR translates to a daily periodic rate of about 0.055% (or 0.00055).

Suppose the cardholder makes a $100 purchase on day 10 of the billing period, increasing the balance to $1,100, with no further transactions or payments during the 30-day month.

Employing this Average Daily Balance Method, the card issuer would multiply $1,000 by 10 for the first 10 days and $1,100 by 20 for the remaining 20 days to obtain a total of $32,000 ($10,000 + $22,000).

Subsequently, the issuer would divide $32,000 by 30 (number of days in the billing period) to ascertain an average daily balance of $1066.67.

To compute the interest charge for the complete 30-day billing period, the issuer would multiply the average daily balance of $1066.67 by the daily periodic rate of 0.055% and then by 30.

In essence, $1066.67 x 0.00055 x 30 = $17.70.

One Method That’s Been Banned

Preceding years saw certain credit card companies employing a technique named double-cycle billing, which based its calculations on the average daily balance over the past two billing cycles. This sometimes led to cardholders paying interest on debts they had already cleared. The Credit Card Accountability Responsibility and Disclosure Act of 2009, also known as the CARD Act, prohibited this practice.

What Is a Grace Period?

A grace period denotes the period between the closure of the billing period and the due date for your credit card payment. Clearing your balance before the grace period lapses enables you to evade interest fees. Grace periods typically extend for at least 21 days but can be longer, and may exclude certain charges like cash advances.

How Can You Find Out if Your Credit Card Uses the Average Daily Balance Method?

The credit card agreement you received upon card signup will specify the method employed by the issuer to determine your finance charges, among other details. If you lack a copy, you can request one from the issuer. As per the Consumer Financial Protection Bureau, “By law, the issuer must make your agreement available to you upon request.”

Is Credit Card Interest Tax Deductible?

No longer, states the Internal Revenue Service, “Credit card and installment interest incurred for personal expenses,” cannot be deducted on your tax return. Before the tax modifications in 1986, however, this deduction was permissible.

The Bottom Line

The Average Daily Balance Method stands as the predominant method for computing finance charges on credit cards today. Understanding its workings can potentially save you money, but the most significant savings come from paying off your balance entirely each month to avoid incurring interest charges.