The average daily balance is the calculation for accrued finance charges on debt utilized by most banks and credit card companies. This amount is usually calculated by taking the balance for each day in a specific period of time, most often a 30-day billing cycle, adding it up, then dividing it by the number of days in the cycle. The sum is then multiplied by a percentage to determine what interest is owed for a billing period.
One way to illustrate how average daily balance works is to use an example from a credit card bill. Credit card companies are the ones who most commonly use this method to calculate how much interest is owed. If a beginning balance is $100 US Dollars (USD) and it is left for 20 days, then $50 USD was added and left there for 10 days, the first part of the balance would add up to $2,000 USD, or $100 x 20 days, and the second part would come to $1,500 USD, or $150 USD x 10 days. The total, $3,500 USD, is divided by the days in the billing cycle, in this case 30 days, for an average daily balance of $116 USD.
The $116 USD would then be multiplied by the annual percentage rate (APR) the credit card company charges, which would then be divided by 12, for the number of months in a year. If, for instance, there was an APR of 12%, the total would be $116 USD x 12%, divided by 12. That would equal a charge for the month of $1.16 USD.
Although credit card companies are the primary users of the average daily balance method, banks also use it to calculate loans, but it is not as common. There are other forms of the average daily balance and the most notable, but less commonly used, is the two-cycle average daily balance. The basic principle is the same, but instead it calculates the finance charge based on the current and previous billing cycle. This is typically more expensive to the consumer overall, unless they pay the balance off every month.
The amount owed under the average daily balance method can be reduced by paying early. When the bill is calculated, the less amount in the daily balance, the less the finance charge will be. Making purchases at the end of a billing cycle also lessens the amount of the average daily balance, which in turn keeps the finance charge down.