The average daily balance method is one of the ways a credit card issuer can calculate finance charges on your credit card. Finance charges are how your credit card issuer charges interest on balances you carry beyond the grace period. Paying a finance charge increases the cost of your credit card debt beyond the original purchase price.
Knowing how your credit card issuer calculates your finance charge can help you estimate the amount of interest you will pay if you don't pay your balance in full. You can check your credit card billing statement or call your credit card issuer to determine if your credit card issuer uses the average daily balance method for calculating finance charges.
The average daily balance method uses your balance during the billing cycle multiplied by the APR for that balance. The average daily balance method can be less expensive compared to some other finance charge calculation methods. Your average daily balance is the sum of your balance on each day of the billing divided by the number of days in the billing cycle.
Here is the calculation for the average daily balance method:
Average Daily Balance x APR x Days in Billing Cycle / 365
Calculating the Average Daily Balance
If you want to calculate your finance charge, you have to know your credit card balance for each day of the billing cycle. While your credit card statement won't list each day's credit card balance, you can use your statement (or your online transaction log) to figure out the balance. Start with the balance at the beginning of the billing cycle. Then, add or subtract from the balance each day you have a new transaction.
Let’s say your APR is 12%, and your billing cycle is 25 days long.
You started the billing cycle with a balance of $100. On Day 4, you made a $100 purchase. On Day 21, a $25 payment was credited to your account. Your daily balance for each day during the billing cycle would be:
Days 1-3: $100
Days 4-20: $200 ($100 purchase)
Days 21-25: $175 ($25 credit)
To calculate your average daily balance, you must total your balance from each day in the billing cycle (even the day's that your balance didn't change) and divide the total by the number of days in the cycle.
(Day 1 Balance + Day 2 Balance + Day 3 Balance…) / number of days in the billing cycle
([$100 x 3 days] + [$200 x 17 days] + [$175 x 5 days]) = $4,575
$4,575 / 25 days = $183
Calculating the Average Daily Balance Finance Charge
Calculating the average daily balance is the hardest part. From there, you simply multiply by your credit card's APR and number of days in the billing cycle to calculate the finance charge.
Based on the details listed above, your finance charge using the average daily balance method would be:
$183 x .12 x 25 / 365 = $1.50
If you continue making minimum payments and no additional charges on this account, you will pay $18 in finance charges over a year.
Why Does the Billing Cycle Matter?
Credit card companies state your interest rate in terms of an annual percentage rate, or APR, to make it easier to compare various credit cards and loans. However, you are not charged interest on an annual basis. You're charged interest periodically based on your billing cycle. Including the billing cycle in the finance charge calculation ensures you are charged interest only for that specific period.
Balances With Different APRs
If you have balances with different APRs on your credit card, the finance charge for these balances is calculated separately. For example, you'll have a finance charge for purchases, one for balance transfers, and one for cash advances if you had all these balances on your credit card. So, if you're calculating your finance charge, you will have to calculate the average daily balance separately for each.