What it is — short definition
– The average daily balance method is a common way credit-card issuers compute the interest (finance charge) you owe. It averages the card balance for each day of the billing cycle, then applies a daily interest rate to that average to produce the monthly interest charge.
Key legal note
– Under the Truth in Lending Act (TILA), card issuers must disclose the method they use to calculate finance charges, the APR (annual percentage rate), fees, and other terms in the cardholder agreement. That makes it possible to compare cards and to request a copy of the agreement from the issuer.
Basic formula
– Monthly interest charge = (Average daily balance) × (Daily periodic rate) × (Number of days in the billing cycle)
– Daily periodic rate = APR ÷ number of days in the year (commonly 365)
How it works — stepwise
1. Determine the balance for each day of the billing cycle. A “daily balance” is the outstanding amount on a given calendar day after applying that day’s payments, credits, purchases and (depending on the method) any prior-day interest.
2. Sum all daily balances for the billing cycle.
3. Divide that sum by the number of days in the billing cycle to get the average daily balance.
4. Multiply the average daily balance by the daily periodic rate and then by the number of days in the cycle to compute the interest charge.
Compounding vs. non-compounding versions
– With compounding: each day’s balance includes any interest charged on previous days. That means interest itself earns interest within the billing cycle.
– Without compounding: daily balances do not include prior-day interest; interest does not compound during the cycle.
– The compounding version results in higher interest for the cardholder.
Other common variations
– Average daily balance including new purchases: new purchases during the billing cycle are counted in the daily balances immediately.
– Average daily balance excluding new purchases: purchases made during the
cycle are ignored when calculating each day’s balance. That means only transactions posted before the billing cycle started (and payments/credits applied during the cycle) affect the average. Card issuers must disclose which variation they use in the cardholder agreement.
Recap of formulas and key terms
– Daily balance on day i: the outstanding balance on that day after posting all transactions and payments for that day.
– Average daily balance (ADB): sum of daily balances ÷ number of days in cycle.
Formula: ADB = (Σ Balance_i) / N, where i = 1…N and N = days in billing cycle.
– Daily periodic rate (DPR): APR ÷ days in year (often 365; some issuers use 360—check your statement).
DPR = APR / 365 (or APR / 360, per issuer).
– Interest charge (non‑compounding method): Interest = ADB × DPR × N.
– Compounding within cycle: Each day’s balance includes prior days’ interest; interest is calculated and added daily, so the effective interest over the cycle is slightly higher than the non‑compounding formula.
Worked numeric example (step‑by‑step)
Assumptions:
– APR = 24% (0.24 annually).
– Billing cycle = 30 days.
– Issuer uses 365-day year for DPR.
– Balances: days 1–10 balance = $1,000; days 11–30 balance = $500.
Step 1 — Compute DPR:
DPR = 0.24 / 365 = 0.000657534.
Step 2 — Compute sum of daily balances:
Sum = 10×1,000 + 20×500 = 10,000 + 10,000 = 20,000.
Step 3 — ADB:
ADB = 20,000 / 30 = $666.67.
Step 4 — Interest (non‑compounding):
Interest = ADB × DPR × 30 = 666.67 × 0.000657534 × 30 ≈ $13.15.
If the issuer compounds daily (adds each day’s interest to the balance), the true interest will be marginally higher; to compute exactly you’d apply the DPR to each day’s balance, update the balance with that day’s interest, and continue — more laborious but straightforward to automate in a spreadsheet.
Comparison with other common methods
– Previous balance method: Interest is based on the balance at the start of the billing cycle (previous statement balance). New charges and payments during the cycle are ignored. This can be more expensive for cardholders who make payments early in the cycle.
– Adjusted balance method: Start with previous balance, subtract payments/credits posted during the cycle, then compute interest on the adjusted amount. New purchases are ignored. This often yields the lowest interest among the three.
– Average daily balance (with or without new purchases): More common and generally falls between previous and adjusted balance outcomes, depending on timing of transactions.
Practical checklist to reduce finance charges (education, not advice)
– Pay the full statement balance by the due date to avoid interest entirely (grace period applies only if you paid prior balance in full and issuer grants a grace period).
– Make larger or earlier payments in the cycle — reducing higher daily balances lowers ADB.
– Time new purchases after you make a large payment (if your card excludes new purchases from ADB, they won’t increase that cycle’s ADB).
– Confirm whether your issuer compounds daily and whether they use a 365‑ or 360‑day year for DPR.
– Read the cardholder agreement for the exact billing method and posting order for payments and transactions.
Common assumptions and caveats
– Issuers’ specific rules (posting order, day-count convention, compounding) vary and materially affect the result. Always check your statement and card agreement.
– DPR may use 365 or 360 days; using the wrong denominator will slightly misstate interest.
– Rounding rules differ by issuer; they can round daily rates, daily interest, or the final interest charge.
Quick spreadsheet implementation (3 columns)
– Column A: Day number (1 to N).
– Column B: Balance at end of day i (after posts/payments).
– Column C: Daily interest = Balance_i × DPR.
– Sum Column C for non‑compounding interest; for compounding, update Balance_i+1 by adding Column C to the next day’s starting balance.
Further reading (official/reputable sources)
– Investopedia — Average Daily Balance: https://www.investopedia.com/terms/a/averagedailybalance.asp
– Consumer Financial Protection Bureau (CFPB) — How credit card interest works: https://www.consumerfinance.gov/ask-cfpb/how-is-credit-card-interest-calculated-en-1798/
– Board of Governors of the Federal Reserve System — Consumer’s Guide to Credit Cards: https://www.federalreserve.gov/creditcard.htm
– Federal Trade Commission — Credit & Loans: https://consumer.ftc.gov/topics/credit-loans
– CFPB — Credit card agreements and disclosures: https://www.consumerfinance.gov/consumer-tools/credit-cards/
Educational disclaimer
This information is educational and does not constitute individualized financial advice or recommendations. Check your cardholder agreement or contact your issuer to confirm the exact billing method and formulas they use.