The average daily balance method is a widely used approach for calculating the interest charges that credit cardholders must pay. It hinges on the card’s outstanding balances for each day within the billing period.
Key Takeaways
- The average daily balance method is a prevalent way of calculating credit card interest charges.
- It considers the card’s outstanding balances on each day of the billing period.
- The average daily balance is multiplied by the card’s daily periodic rate and the number of days in the billing period.
- The daily periodic rate is the card’s annual percentage rate (APR) divided by 365 (or 366 in a leap year).
Understanding the Average Daily Balance Method
Federal laws require credit card issuers to clearly disclose their methods for calculating finance charges along with other vital terms, making it easier for consumers to compare different credit cards.
To calculate finance charges, card issuers may use several methods, including:
- Average daily balance method: This method uses the balance at the end of each day of the recent billing cycle to determine finance charges.
- Previous balance method: Here, interest charges are calculated based on the amount owed at the start, rather than the end, of the latest billing cycle.
- Adjusted balance method: Finance charges are computed by taking the amount owed at the end of the previous billing period minus any credits and payments during the current period. New purchases are not reflected until the next month.
If you pay your credit card balance in full each month, you won’t incur any interest charges.
How the Average Daily Balance Method Works
The average daily balance method can be calculated with or without compounding. Regardless of the approach, the formula is:
Average daily balance × daily periodic rate × number of days in the billing cycle = interest charge for that month
The calculations differ slightly depending on whether compounding is applied:
With Compounding
For the average daily balance method with compounding, the issuer takes the balance at the beginning of each day, adds new charges and the previous day’s interest, and subtracts any payments or credits. The issuer sums these daily balances and divides by the number of days in the billing cycle to find the average daily balance.
Without Compounding
In this method, the previous day’s interest is not added into the daily balances, meaning the interest does not compound. This approach typically results in lower charges compared to the compounding method.
Different variations include average daily balance with new purchases and average daily balance excluding new purchases. While the former method factors new purchases immediately, the latter delays including them until the next billing period.
Example of Average Daily Balance Method
Here’s a simplified example using the non-compounding method:
Suppose a credit card has a balance of $1,000 at the beginning of the billing period and an APR of 20%, translating into a daily periodic rate of about 0.055% (0.00055).
The cardholder makes a $100 purchase on day 10, raising their balance to $1,100, with no further transactions throughout a 30-day month.
To find the average daily balance, the issuer would multiply $1,000 by 10 (days) and $1,100 by 20 (days), totaling $32,000. Dividing by the 30 days in the billing cycle gives an average daily balance of $1066.67.
The interest for the period would be $1066.67 × 0.00055 × 30 = $17.70.
Understanding Grace Periods
A grace period is the interval between the end of the billing period and the due date for your payment. Paying your balance within this period can help you avoid interest. Grace periods are usually 21 days or longer.
Checking If Your Card Uses the Average Daily Balance Method
You can find the specified method for calculating finance charges in your credit card agreement, which the issuer must provide upon request.
Are Credit Card Interest Payments Tax-Deductible?
Generally, no. Personal credit card interest is not tax-deductible under current IRS regulations, a change from the rules prior to tax reform in 1986.
Conclusion
The average daily balance method is the most commonly employed way to calculate finance charges on credit cards. Knowing the specifics can help you save money, especially if you can pay off your balance each month and avoid interest in the first place.
Related Terms: previous balance method, adjusted balance method, double-cycle billing, grace period, cash advances.
References
- Consumer Financial Protection Bureau. “Credit Card Contract Definitions”.
- Financial Security for All. “How Do Credit Card Companies Determine the Balance on Which Interest Is Charged?”
- Capitol One. “Grace Period: What It Is and How It Works for Credit Cards”.
- Consumer Financial Protection Bureau. “What Is a Grace Period for a Credit Card?”
- Consumer Financial Protection Bureau. “Credit Card Agreement Database”.
- Internal Revenue Service. “Topic No. 505, Interest Expense”.
- Urban Institute. “Reforming the Mortgage Interest Deduction”, Page 1.
