The “average daily balance” is a term many of you may have seen printed in terms and conditions or on your billing statement but what exactly does it mean? And, what is the formula that creditors use to calculate the ADB?
average daily balance definition: The average balance on your credit card during a given billing cycle (usually a 30 day period). This is calculated by adding together the balance for each day and dividing that total amount by the number of days in the cycle.
This is by far the most common method credit card companies use for calculating finance charges. Not surprisingly, it’s usually the most profitable formula for them when you contrast it to the adjusted balance method, where interest is based off the balance at the end of the billing cycle (helpful if you make big payments before a cycle’s closing date).
But going back to the average daily balance method, here’s how you calculate it. For simplicity, I will first explain the concept without the finance charges included.
Example: The billing cycle is 30 days
Day 1: The cycle begins with a $1,000 balance
Day 5: A new purchase of $300 is made
Day 10: A minimum payment due of $50 is applied to the account
This would mean that for days 1 thru 4, your daily balance was $1,000. So we would add those up ($1,000 + $1,000 + $1,000 + $1,000 = $4,000).
Then on day 5 you made a purchase of $300 and that means your new balance is $1,300. So for days 5 through 9 your balance would be $1,300 ($1,300 + $1,300 + $1,300 + $1,300 + $1,300 = $6,500).
Now we’re on day 10 when you made a $50 payment. Your new daily balance is $1,250 ($1,300 – $50). Since you have no other activity for the rest of the cycle, that amount would be your daily balance for days 10 through 30 (remember that’s including day 10, so it’s 21 total. $1,250 x 21 = $26,250).
The final calculation – We add up those three totals: $4,000 + $6,500 + $26,250 = $36,750. Now divide that amount by 30 and we get $1,225 as your average daily balance.
But it gets more cumbersome…
Because you have to calculate the balance for each day, it certainly can involve a lot of calculations!
To make matters worse, the example above is a very simple cycle with just 3 events happening. I would suspect most of you out there probably have a lot more going on during a given period. Calculating the average daily balance including new purchases (possibly dozens) and subtracting credits (both payments and returns) will make the math even more tedious. But if you enjoy crunching numbers, then knock yourself out!
What’s the interest?
Now that we’ve finished calculating the average daily balance, the interest charges will be determined for the billing cycle period.
The formula to do this is: (days in billing cycle ÷ 365) x APR x average daily balance. Here’s the math showing those calculations…
Step One: You must determine the amount of interest being charged to your account each month (the stated APR). But first we determine the daily factor to apply by dividing the number of days in your billing cycle by the number of days in a year (30 ÷ 365 = 0.08219). That factoring amount is the fraction of your APR interest you are charged per cycle.
Step Two: We take that 0.08219 and multiply it by your 15% APR (that’s 0.15 on a calculator) and we get 0.01233.
Step Three: The final step is multiplying that 0.01233 by your average daily balance of $1,225. The result? 15.10. That means during that cycle, you were charged $15.10 of interest.
While this mathematical exercise is not easy, at least you can now say you are now among the few that actually understands how it works!
This article was written or last updated February 2016