Average Daily Balance Method: Definition and Calculation Example (2024)

What is the Average Daily Balance Method?

The average daily balance method is a common way that credit card issuers calculate the interest charges cardholders have to pay. It is based on the card's outstanding balances on each day of the billing period.

Understanding the Average Daily Balance Method

The federalTruth-In-Lending Act(TILA) requires credit card issuers to disclose their method of calculating finance charges, as well as the annual percentage rate (APR), fees, and other terms on the card, in theirterms and conditions statement. Providing these details makes it easier for consumers to compare different credit cards.

To calculate their finance charges, card issuers can use any of several different methods. Among them are:

• Average daily balance method. The subject of this article, and the most common method today, it uses the balanceat the end of each day of the just-ended billing cycle to calculate finance charges, as explained below.
• Previous balance method. Here, interest charges are based on the amount owed at the beginning, rather than end, of the latest billing cycle.
• Adjusted balance method. This method bases finance charges on the amount owed at the end of the previous billing period minus any credits and payments made during the current period. New purchases won't be reflected until the next month's billing statement. Of these three methods, this one is the least common.

How the Average Daily Balance Method Works

The average daily balance method can take several different forms, including calculations made with or without compounding.

In either case, the formula is:

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

The computations with and without compounding differ in how they define "daily balance."

In the average daily balance method with compounding, the issuer takes the balance at the beginning of each day, adds any new charges for that day plus any interest charges on the previous day's balance, and then subtracts any payments or credits made that day.

The issuer then adds up all of the daily balances and divides that total by the number of days in the billing cycle. The result is the average daily balance.

Following the formula above, the average daily balance is then multiplied by the daily periodic rate (the annual percentage rate divided by the number of days in the year) and finally by number of days in the billing cycle. The result is how much the card issuer will charge in interest for that month.

The average daily balance method without compounding works much the same way, except that the card issuer doesn't add in the previous day's interest in determining the daily balances. Because of that, the interest does not compound, as it does with the other method.

The method with compounding will be more expensive for cardholders, and more lucrative for card issuers, than the one without.

Other variations on the average daily balance method include average daily balance including new purchases and average daily balance excluding new purchases. The former works like the average daily balance method explained above. The latter doesn't add in purchases made during that billing period until the next period.

Average Daily Balance Method Example

Here's a simplified example of the average daily balance method without compounding.

Suppose a credit card has a balance of $1,000 at the beginning of the billing period and an APR of 20% (or 0.20). That APR translates into a daily periodic rate of about 0.055% (or 0.00055).

The cardholder makes a $100 purchase on day 10 of the billing period, raising their balance to $1,100, and but no other purchases or payments during the month (which happens to have 30 days).

Using 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 20 remaining days. That total would be $32,000 ($10,000 + $22,000).

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

Finally, to compute the interest charge for the full 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 other words, $1066.67 x 0.00055 x 30 = $17.70.

One Method That's Been Banned

In years past, some credit card companies used a method known as double-cycle billing, which based its calculations on the customer's average daily balance over the last two billing cycles. That sometimes resulted in cardholders paying interest on debt they had already paid off.The practice was banned by the Credit Card Accountability Responsibility and Disclosure Act of 2009, better known as the CARD Act.

The Bottom Line

The average daily balance method is the most commonly used way of computing finance charges on credit cards today. Knowing how it works may save you some money, but you'll save even more if you can pay your balance in full each month and not incur interest in the first place.