The average daily balance method is one of the ways in which a credit card issuer calculates the finance charges or interest on your card. 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'll pay if you don't pay your balance in full in a given month. You can check your credit card billing statement or call your credit card issuer to determine if it uses the average daily balance method for calculating finance charges.
- The average daily balance method of calculation begins with your balance on each day of the billing cycle divided by the number of days in the cycle. Then it multiplies this figure by your annual percentage rate.
- Credit card companies express your interest rate as your annual percentage rate, but you're not charged interest on an annual basis.
- You must take an additional step to calculate your actual finance charge.
Definition and Example of Average Daily Balance
Your average daily balance is the sum of your balance on each day of the billing cycle divided by the number of days in the cycle. 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.
The finance charge is calculated separately if you have balances with different APRs on your credit card. For example, you might have a finance charge for purchases, one for balance transfers, and another for cash advances on the same card. You'd have to calculate the average daily balance separately for each to calculate your finance charge.
How Do You Calculate the Average Daily Balance?
Multiply your annual percentage rate by the number of days in the billing cycle. Divide this number by 365, the number of days in a year.
How the Average Daily Balance Works
Credit card companies state your interest rate in terms of the annual percentage rate, or APR. This makes it easier to compare various credit cards and loans. But you're not charged interest on an annual basis. You're charged periodically based on your billing cycle. Including the billing cycle in the finance charge calculation ensures that you're charged interest only for that specific period.
Calculating the average daily balance is the hardest part. From there, you simply multiply by your credit card's APR and the number of days in the billing cycle to calculate the finance charge.
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. You made a $100 purchase on Day 4. A $25 payment was credited to your account on Day 21. 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)
You must total your balance from each day in the billing cycle to calculate your average daily balance, even the days that your balance didn't change. 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
Limitations of the Average Daily Balance
Your average daily balance doesn't tell you the finance charge, so you have to take another step to determine this.
You have to know your credit card balance for each day of the billing cycle to calculate your finance charge. Your credit card statement won't list each day's balance, but you can use your statement (or your online transaction log) to figure it out. Start with the balance at the beginning of the billing cycle, then add or subtract from the balance each day that you have a new transaction.
Based on the details used in the above scenario, your finance charge using the average daily balance method would be:
- $183 x .12 x 25 / 365 = $1.50
You'll pay $18 in finance charges over the course of a year if you continue making minimum payments and no additional charges on this account.
Frequently Asked Questions (FAQs)
Which method of calculating finance charges is most favorable to the consumer?
The adjusted balance method usually works out in the consumer's favor. Finance charges are calculated after payments are deducted using this method. The previous balance method is the worst because it tallies interest before payments are deducted. The average daily balance method falls in between these two.
How can you avoid credit card finance charges?
Be sure to pay your balance in full and on time every month if you don't want to pay finance charges on your credit card. You'll be charged interest on any statement balance you don't pay by the due date.