The Average Daily Balance Method: What is it?
The average daily balance method is one approach that credit card issuers frequently use to calculate the interest that cardholders must pay. It is determined by the balance due on the card for each day of the billing cycle.
Comprehending the Average Daily Balance Approach
Credit card issuers are required by the federal Truth-In-Lending Act (TILA) to provide information about how they calculate finance charges, fees, the annual percentage rate (APR), and other terms on the card in their terms and conditions statement. Giving customers access to these facts facilitates their comparison shopping for credit cards.
Card issuers have many options for calculating their financing costs. Among them are:
- Daily average balance approach. This article’s method—which is now the most often used—calculates financing charges by using the amount after each day of the recently concluded billing cycle, as will be detailed below.
- Prior ways of balancing. In this case, interest is calculated using the balance due at the start of the most recent billing period rather than the end.
- Technique of adjusted balance. This technique calculates financing costs by deducting any credits and payments received during the current billing period from the total amount outstanding at the end of the preceding billing period. The following month’s billing statement is when new purchases will be shown. This is the least used of the three techniques.
Interest-free credit card payments are made when the balance is paid off each month.
The Workings of the Average Daily Balance Method
The average daily balance approach has several variations, such as computations done with or without compounding.
In either scenario, the equation is:
Interest charged for that month is calculated as follows: average daily balance x daily periodic rate x number of days in the billing cycle.
Compounded and uncompounding calculations have different definitions of “daily balance.” The issuer takes the amount at the start of each day, adds any new charges for that day and any interest charges on the balance from the previous day, and then deducts any payments or credits made that day in the average daily balance method with compounding.
After adding up all of the daily balances, the issuer then divides the sum by the number of days in the billing cycle. The average daily balance is the outcome.
Applying the calculation mentioned above, the average daily balance is multiplied by the number of days in the billing cycle, the daily periodic rate, and the yearly percentage rate divided by the number of days in the year. The amount the card issuer will charge in interest that month is the outcome.
With one exception—the card issuer does not include the interest from the prior day when calculating the daily balances—the average daily balance technique without compounding operates substantially similarly. As a result, unlike with the other approach, the interest does not compound. Compared to the system without compounding, the one with compounding will be more costly for cardholders and more profitable for card issuers.
The average daily balance approach also comes in two variations: the average daily balance with new purchases and the average daily balance without new purchases. The former operates similarly to the previously described average daily balance technique. Purchases purchased during that billing period are not included until the next period.
Example of Average Daily Balance Method
This condensed illustration of the average daily balance approach without compound interest. Assume a credit card with an APR of 20% (or 0.20) and a $1,000 balance at the start of the payment cycle. The daily recurring rate that results from such APR is approximately 0.055%, or 0.00055.
On day 10 of the billing cycle, the cardholder makes a $100 transaction, increasing their balance to $1,100. Throughout the month, which consists of 30 days, the cardholder makes no other purchases or payments.
Using this average daily balance technique, the card issuer would multiply $1,000 by 10 for the first ten days and $1,100 by 20 for the last 20 days. $32,000 would be the total ($10,000 + $22,000).
Next, the issuer would calculate the average daily amount of $1066.67 by dividing $32,000 by the number of days in the billing cycle, which is thirty.
Lastly, the issuer would multiply the average daily balance of $1066.67 by the daily periodic rate of 0.055% and then by 30 to get the interest charge for the 30-day billing period.
Stated otherwise, $1066.67 x 0.00055 x 30 = $17.70.
One Technique That’s Been Prohibited
A practice known as “double-cycle billing” was employed by certain credit card issuers in the past. This approach involved calculating the client’s average daily balance over the previous two billing cycles. This occasionally led to cardholders paying interest on debt they had already settled. The Credit Card Accountability Responsibility and Disclosure Act of 2009, or CARD Act for short, outlawed the practice.
A Grace Period: What Is It?
The interval of time between the conclusion of the billing cycle and the due date for credit card payments is known as the grace period. You can avoid paying interest if you settle your debt before the grace period expires. Grace periods can be extended and typically run for at least 21 days, albeit they may not cover all expenses, including cash advances.
How Can You Tell Whether Your Credit Card uses the Average Daily Balance Method?
The method the issuer employs to calculate your finance costs is disclosed, along with other details, in the credit card agreement you got when you applied for the card. You can ask the issuer for a copy if you no longer own one. As to the Consumer Financial Protection Bureau, “The issuer is required by law to provide you with access to your agreement upon request.”
Is Interest on Credit Cards Tax Deductible?
Not any longer. “Credit card and installment interest incurred for personal expenses,” according to the Internal Revenue Service, is not allowed as a tax deduction on your return. But before the 1986 tax amendments, it was deductible.
The most often utilized technique for calculating credit card financing charges nowadays is the average daily balance approach. Understanding how it operates might help you save a little money, but if you can pay off your debt in full each month and avoid paying interest in the first place, you’ll save much more.
Conclusion
- One popular approach for figuring out credit card interest is the average daily balance method.
- It is determined by the balance due on the card for each day of the billing cycle.
- The daily periodic rate on the card and the number of days in the billing cycle are multiplied by the average daily balance.
- The card’s annual percentage rate (APR) is divided by 365 (or 366 in a leap year) to get the daily periodic rate.
