Definition
The Average Daily Balance is a calculation used primarily by credit card companies to compute interest charges. It represents the sum of each day’s balance in the billing cycle divided by the total number of days in the cycle. The higher the daily balance, the higher the interest charges will be.
Key Takeaways
- The Average Daily Balance is a method used by credit card companies to calculate interest charges. It is computed by adding up the balances at the end of each day in a billing cycle and then dividing that result by the number of days in that billing cycle.
- It is a common method of calculation for various financial products, and may also apply to savings accounts, loans, or other types of credit. In the context of a savings account, it might be used to calculate the amount of interest paid to the account holder.
- The Average Daily Balance encourages consumers to pay off their balances as quickly as possible. The fastest way to decrease interest charges would be to reduce the average daily balance, which can be achieved by making payments early in the billing cycle.
Importance
The finance term “Average Daily Balance” is crucial because it offers a more accurate calculation of interest accrued on certain types of accounts like credit cards and loans.
Banks and other financial institutions calculate the average daily balance by adding up the balance at the end of each day in the billing cycle and dividing by the number of days in that cycle.
This method, therefore, includes any daily changes and transactions, offering a holistic view of the account’s status.
So, it is vital for consumers to understand this term as it directly impacts the amount of interest they will be liable to pay on their credit or loan amounts.
Explanation
The Average Daily Balance is a calculation used primarily by credit card companies to determine the interest charges for a particular billing period. The purpose of using the Average Daily Balance method is to ensure accurate calculation of interest based on the actual amount outstanding each day.
This method takes into account the day-to-day fluctuation in account balances, which makes it more precise and responsive to the user’s actual credit card usage. The Average Daily Balance plays a crucial role in credit card billing as it includes all new purchases and payments.
If a customer pays their bill earlier in the billing cycle or makes additional purchases, all these transactions will affect the average daily balance, thus affecting the interest charged. Moreover, financial institutions also use the average daily balance to calculate interest on savings and checking accounts.
It benefits users because the more frequently they deposit money into their accounts, the higher their average daily balance will be, which could lead to earning more interest.
Examples of Average Daily Balance
Credit Card Billing: Credit card companies use the average daily balance to calculate the interest charges for the billing cycle. For example, if you have a $1000 balance on your credit card for 15 days and then you pay off $500, leaving a balance of $500 for the other 15 days of a 30-day month, the credit card company would calculate your average daily balance as $750 (($1000*15 + $500*15) / 30). This would be the basis on which they would calculate the finance charges for the next billing cycle.
Savings Account: Banks calculate interest on savings accounts using the average daily balance method. For instance, if you started the month with $5,000 in your account, then deposited $1,000 mid-month, your average daily balance for the month would be $5,500 (($5,000*15 + $6,000*15) / 30). The bank would then use this number to compute the monthly interest you earn.
Line of Credit or Loans: If you’ve taken out a line of credit or a flexible loan where the balance can change during the month, the bank will use the average daily balance to calculate the interest owed. For instance, if you had a loan balance of $10,000 for half the month and then repaid $2,500 (down to $7,500) for the second half of the month, the average daily balance would be $8,750 (($10,000*15 + $7,500*15) / 30) and this would be used to calculate the interest owed.
FAQs about Average Daily Balance
What is Average Daily Balance?
The Average Daily Balance is a finance term that refers to the calculation of an account’s balance over a billing period, which is typically a month. To compute for the average daily balance, you need to add each day’s balance for the billing cycle and then divide by the total number of days in the billing cycle.
How is the Average Daily Balance used?
Average Daily Balance is often used by credit card companies to calculate interest charges. The advantage of using the average daily balance method for the cardholder is that if a large portion of the credit card balance is paid off early in the billing cycle, the average daily balance and the interest charged would be lower.
How can I calculate my Average Daily Balance?
To calculate your average daily balance, you would add up your balance for each day of the billing cycle, then divide that total by the number of days in the billing cycle. This will give you the average daily balance.
Does the Average Daily Balance differ from the ending balance on my statement?
Yes, the average daily balance is generally different from the ending balance on your statement. The ending balance is the amount you owe at the end of the billing cycle, while the average daily balance is an average of your balance throughout the month.
Related Entrepreneurship Terms
- Compound Interest
- Principal Amount
- Interest Rate
- Credit Balance
- Billing Cycle
Sources for More Information
- Investopedia: This is a comprehensive online resource focused on investing and finance education. It contains articles, tutorials, and dictionary terms. Average Daily Balance is one of them.
- Bankrate: It’s a website specifically focused on rates and banking information, where you can get information on Average Daily Balance and other finance terms.
- NerdWallet: On this website, users are provided with personal finance tools and advice. It covers various finance topics including Average Daily Balance.
- Credit Karma: This platform provides free credit scores, reports, and insights. You can also get information about Average Daily Balance and other finance-related terms.
