What is the Average Daily Balance Method?
The average daily balance method is a method for calculating the amount of interest to be charged to a borrower on an outstanding loan. It is an accounting method that is most commonly used by credit card issuers to calculate financing charges applied to any outstanding balance you may have on a credit card.
The average daily balance method may also be used to calculate the interest that you will earn on an interest-bearing deposit account.
- 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 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.
Computing Interest Charges with the Average Daily Balance Method
In short, the average daily balance method calculates interest charges, such as for a credit card, by multiplying the credit card balance for each day during a billing period by the card’s finance charge, which is stated as the card’s annual percentage rate (APR). Thus, there are three components for calculating interest charges using the average daily balance method:
- The annual percentage rate interest charge applied to outstanding balances on the card
- The card’s billing cycle or period
- The outstanding balance due on the card each day of the billing cycle
The formula for calculating monthly interest charges then appears as follows:
The annual percentage rate and the days in the billing cycle are set figures. What changes from month to month, as you make charges to the card and payments on the balance, is the average daily balance. Here’s an example:
Assume that you have a credit card that charges an APR of 15%, with a 25-day billing cycle, and that at the beginning of a new billing cycle, you have a $200 balance on your card. On the 7th day of the billing cycle, you use the card to make a new purchase that totals $100. Then, on the 20th day of the billing cycle, you make a payment of $50 against the card’s outstanding balance.
Given the above circumstances, your daily balance for each day in the billing cycle would be as follows:
- Day 1-6, the daily balance is $200
- Day 7-19, the daily balance is $300 (due to the $100 purchase made on day 7)
- Day 20-25, the daily balance is $250 (following your $50 payment)
Now, in order to calculate your average daily balance for the entire billing cycle, you have to calculate the sum total of the balance for every day in the billing cycle and then divide the total by the number of days in the billing cycle, e.g., 25.
The calculation would look as follows:
[($200 x 6 days) + ($300 x 13 days) + ($250 x 6 days)] / 25 = $264
Then, in order to find your interest charges for the period using the average daily balance method, you plug the $264 figure into the formula: (APR x No. of Days in the Billing Cycle x Average Daily Balance) / 365. The calculation would be the following:
[.15 (APR) x 25 (Days in the Billing Cycle) x 264 (Average Daily Balance)] / 365 = $2.71
Significance of the ADB Method
Looking at how the average daily balance method calculation works reveals 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.
Note: Many credit card issuers charge a different APR for cash advances than they do for purchases made with the card. Therefore, if you have taken out a cash advance with your card, you would have to do separate average daily balance method calculations for the cash advance amount owed on your card and for the outstanding balance for purchases made with the card.
CFI is the official provider of the global Certified Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: