Understanding the Average Daily Balance

Average daily balance can be described as the amount of money that is contained in an account over a certain length of time. Adding each day's balance within that time period and dividing by how many days comprise it determine the average daily balance. The average daily balance is often used to establish the finance charge that will be included on unpaid debts. What this really means is that the actual amount the credit card user will owe is determined by the total sum plus interest owed at the end of each day.

What is the significance of an average daily balance? Many times this method is used to determine the amount of interest that will be included in your overall credit card balance.

For example, Sam uses his credit card to purchase $1,000 worth of electronics merchandise on March 5 and neglects to pay his bill in time for purchases made during a 31-day billing cycle (March 1-31) when it comes due on April 19. In order to determine the appropriate finance charge (using the average daily balance method), the interest is calculated from the date of purchase.

In other words, no interest is charged from March 1-5, so that equates to $0 for those four days. For the remaining 27 days, the average daily balance is calculated via the following equation:

(($0 x 4 days) + ($1,000 x 27 days)), ÷ 31 (days in the billing period),

Or $0 + $27,000 ÷ 31 = an average daily balance of $870.97.

The amount of interest would then be calculated by multiplying the average daily balance by the store's daily percentage rate (which is calculated by dividing the annual percentage rate, or APR, by the number of days in the year) and the number of days in the billing cycle. So if Sam shopped at Store XYZ, spent $1,000 and had an average daily balance of $870.97, a daily percentage rate of 0.054795% across 31 days in the billing cycle would render him an interest payment of $870.97 x 0.054795% x 31, or an interest charge of $14.79.

An advantage of the average daily balance method for calculating interest is that any payments made are immediately factored into the equation, thus lessening the total amount of interest due. Once a balance has been partially paid off, the interest will inevitably decrease because the average daily balance has decreased. New purchases may or may not be included in this calculation depending on the merchant or creditor.

Interest charges determined by the average daily balance method are often elevated above those figured by the adjusted balance method. Rates are usually lower, however, than those determined by the previous balance method.

Who uses this method?

Many department stores employ the average daily balance method for calculating interest on their credit card users' purchases. Despite the fact that these stores use the average daily balance method, the interest rates on the credit cards, many times, are higher than on traditional credit cards. Standard credit card companies also use this method to calculate interest payments. Additionally, banks may offer accounts that earn interest based on the average daily balance method once the account reaches a certain benchmark.