What is the Average Daily Balance Method?

What is the Average Daily Balance?

The average daily balance is a common accounting method that calculates interest charges by considering the balance invested or owed at the end of each day of the billing period, rather than the balance invested or owed at the end of the week, month, or year.

Summary

  • The average daily balance method is a method for calculating the amount of interest to be charged to a borrower on an outstanding loan.
  • The ADB method is an accounting method commonly used by credit card issuers to calculate financing charges applied on outstanding balances due on a credit card.
  • Understanding the average daily balance method can help you reduce financing charges by making payments and purchases at advantageous times during your billing cycle.
The average daily balance method is a method for calculating the amount of interest to be charged to a borrower on an outstanding loan.

How the Average Daily Balance Method Works

The balance of a credit card fluctuates from day to day as the cardholder makes purchases and payments on the account. The credit card company needs a way to determine how much to charge in interest at the end of the billing cycle. One of these ways is the average daily balance.

To calculate the average daily balance, the credit card company takes the sum of the cardholder’s balances at the end of each day in the billing cycle and divides that amount by the total number of days in the billing cycle. Then, the company multiplies this figure by the card’s annual percentage rate, or APR, to determine interest charges.

The average daily balance is only used for people who haven’t paid off their statement balance on time at the end of the month. Many people will have a grace period during which they can pay the unpaid balance. However, on the first day after the end of the grace period, the credit card company will start charging interest based on the average daily balance.

Average daily balance example

Kory started the billing cycle with a $100 balance. This would be his daily balance until he makes another purchase or payment. If he makes a $50 purchase on day 5, the daily balance would increase to $150. The rest of his charges look like this:

  • Day 1: $100 (balance).
  • Day 5: $50 (charge).
  • Day 15: $200 (charge).
  • Day 20: $50 (charge).

By adding the balance of Day 1, Day 2, Day 3, and so on, the total would be $7,650 for the entire 30-day billing cycle. Kory divides $7,650 by 30 to get an average daily balance of $255. This is the amount that the credit card company uses to determine his interest charges.

Significance of the ADB Method

Looking at how the average daily balance method calculation works reveal that any time you are carrying an outstanding balance on a credit card, it is to your advantage to make a payment on the card as soon as possible since that will reduce your average daily balance for the next billing cycle.

Another takeaway is that you can also reduce your average daily balance and the resulting finance charges by delaying purchases made with your card until as late as possible in your current billing cycle. Your billing cycle information is shown on each billing statement that you receive for your credit card.

It’s also important just to know whether your credit card issuer uses the average daily balance method for computing finance charges. While most credit card issuers in the United States do customarily use the average daily balance method, some calculate finance charges using one of two other possible methods.

The beginning balance method applies interest charges to the outstanding balance on your card at the beginning of each billing cycle. The other alternative finance charge method is the adjusted balance method, which bases interest charged on the outstanding balance at the end of each billing cycle.

Average Daily Balance Method Vs. Adjusted Balance Method Vs. Previous Balance Method

Interest charges using the average daily balance method should be lower than the previous balance method, which charges interest based on the amount of debt carried over from the previous billing cycle to the new billing cycle.

On the other hand, the average daily balance method will likely incur higher interest charges than the adjusted balance method because the latter bases finance charges on the current billing period’s ending balance.

Card issuers use the adjusted balance method much less frequently than either the average daily balance method or the previous balance method.