What Does the Average Daily Balance Technique Mean?
The average daily balance strategy is a favored approach for calculating credit card interest. It counts on the outstanding balance on your card daily during the billing cycle. Each daily balance contributes to the total, determining how much you pay in interest.
Main Points to Remember
- This technique is a standard way for computing interest on credit cards.
- It considers the balance on your card each day throughout the billing span.
- The daily balance average is multiplied by both the daily interest rate and the number of days in the billing cycle.
- The annual percentage rate (APR) is the daily rate divided by 365, or 366 in leap years.
Different Ways to Calculate Finance Charges
Financial institutions use several methods to calculate finance charges on loans and credit products, each with its unique approach. One common approach is the average daily balance method. This method typically involves taking the outstanding balance at the end of each day during the billing cycle. The daily amounts are averaged over the cycle to determine applicable interest charges.
Another approach is the previous balance method. With this method, interest is calculated using the balance that was at the start of the billing period. This means it doesn't account for any payments or purchases made during the billing cycle.
The adjusted balance method takes a slightly different approach, but it is less commonly used by lenders. Here, finance charges are based on the balance at the end of the prior billing period minus any payments or credits received during the current period. Purchases made in the current period don't influence the calculated balance until the next billing period.
Understanding these methods can help you better assess the overall interest and fees involved in your credit or loan accounts, enabling more informed financial decisions. It’s crucial for you to know well how these calculations may affect your obligations.
How the Daily Balance Calculation Method Operates
Daily Balance Calculation with Interest Growth
In this approach, the balance at the start of each day is adjusted. New charges are added, and any interest charges from the previous day's balance are also incorporated. Payments and credits made throughout the day are subtracted. The issuer then sums up all daily balances and divides by the number of days in the billing period to find your average daily balance.
The monthly interest charge involves multiplying the average daily balance by the daily periodic rate, which is the annual percentage rate divided by 365, and then by the number of days in the billing period. This results in the interest charge you will see on your monthly statement.
Daily Balance Calculation Without Interest Growth
This method functions similarly, but it does not include the interest from the previous day's balance in calculating daily balances. This means the interest charges do not grow day by day like in the compounding method. By excluding the previous day’s interest, this approach can be less costly for cardholders and results in a smaller interest charge each month.
Alternative Approaches
There are other ways to implement the daily balance calculation method. One approach includes new purchases when calculating average daily balances, following a similar process as previously described. Another excludes those purchases until the next billing period, which can impact how interest costs accrue over time.
Example of Calculating an Average Daily Balance
To comprehend how the average daily balance method works, let's explore a scenario involving a credit card balance. Imagine your credit card starts with a balance of $1,000 at the beginning of a billing cycle. The annual percentage rate (APR) for this card is 20%, translating to a daily rate of approximately 0.055% (or 0.00055).
On the 10th day of the billing cycle, you make a purchase of $100, bringing your balance to $1,100, with no further transactions occurring during the 30-day cycle. To calculate the average daily balance, the outstanding balances are calculated as follows:
- First 10 days: Multiply the initial $1,000 balance by 10 days.
- Remaining 20 days: Multiply the new $1,100 balance by 20 days.
This results in a total of $32,000 ($10,000 from the first 10 days and $22,000 from the remaining 20 days). You then divide this total by the number of days in the billing period, which is 30, resulting in an average balance of $1,066.67.
For the interest calculation, take your average daily balance ($1,066.67) and multiply it by the daily rate (0.00055). Finally, multiply by 30 days to find the interest charge for the month: $17.70.
One Method That's Been Banned
Double-cycle billing was a method used by some credit card companies in the past. This approach calculated interest based on the average daily balance across two billing cycles. Unfortunately, it often meant you paid interest on amounts previously paid off. Due to its unfair nature, this practice was discontinued under the CARD Act of 2009, ensuring more transparent billing for credit card users.
What Is a Grace Period?
A grace period is the span of time you have after your billing cycle ends to make your credit card payment without incurring interest charges. By settling your balance in full before this period concludes, you can bypass extra costs. Typically, grace periods last at least 21 days but can extend further. Keep in mind, they might not apply to all transactions, like cash advances.
How to Determine if Your Credit Card Uses the Average Daily Balance Method
The credit card agreement you initially received details the method used by the issuer to calculate finance charges. If you can't find this document, you can request another copy from your card issuer. Legally, they are required to provide it upon your request. Reviewing this agreement will help you understand if the average daily balance method applies to your card.
Can You Deduct Credit Card Interest?
Credit card interest from personal expenses isn't deductible on your tax return. This change came about with the tax reforms in 1986. Prior to this, you could deduct such interest.
Key Takeaway
Understanding the average daily balance method is essential for managing credit card debt. This method is used to calculate finance charges, impacting your accounting and credit score. By paying off your balance in full each month, you can reduce interest charges. This practice promotes transparency and fairness while also benefiting your savings account.
