Reader Question: What is Average Daily Balance?

Matt wrote in last week with a very good, very tough question about a certain credit card billing practice:

I am confused by my credit card agreement definition of the "average daily balance method" of finance charge calculation. When I look this definition on the web the most common definition is this:

Average Daily Balance. This is the most common calculation method. It credits your account from the day payment is received by the issuer. To figure the balance due, the issuer totals the beginning balance for each day in the billing period and subtracts any credits made to your account that day. While new purchases may or may not be added to the balance, depending on your plan, cash advances typically are included. The resulting daily balances are added for the billing cycle. The total is then divided by the number of days in the billing period to get the "average daily balance."

But my credit card company also adds that finance charges accrue and are compounded on a daily basis. This confuses me. Can you please explain this to me and help me understand how this fits into the average daily balance method?

Matt is hardly alone in being confused by this credit card term. It's something I've studied often and still have a hard time explaining!  The definition he quoted is correct, but doesn't help clarify much. Here's how it works:

Let's use April as an example: If you started with $200 balance on your credit card, charged $20 each day from the 2nd through the 10th, $1,000 on the 11th, paid it all off on the 12th and then charged nothing from the 13th to the 30th, your average daily balance calculation would be $142.66. If you had a 12% APR, you would be charged $1.42 for that month.

1- $200      
2- $220      
3- $240         
4- $260
5- $280
6- $300
7- $320
8- $340
9- $360
10- $380
11- $1,380
12 through 30- $0

With adjusted balance method (the best for consumers), you wouldn't pay any interest on this balance because you owed $0 at the end of the statement. With the previous balance method, you would pay $2 in interest for the $200 balance you had from March even though you paid it off in April.

Some issuers use "double cycle" or "two cycle" average daily balance billing which is even more complicated and expensive. Double cycle billing takes the average balance from the last two months, even if you paid part of the previous balance. For example: You had a $1,000 balance in March and paid $500 of it.  You don't add any new charges in April, but the credit card issuer charges you interest on the full $1,000 instead of just the $500 you had remaining.

Oh, and don't forget the minimum finance charge. Most credit cards will charge you a minimum interest charge of $0.50 if your real interest charge is below that amount and more than zero. But now some credit card issuers, including Bank of America, are increasing this minimum to $1.50. That means that our $1.42 example above would more likely be $1.50 instead.

Is your brain hurting yet? I think my math here is accurate, but am open to corrections if there are any mathematicians or credit card issuers out there with a better explanation for Matt.

Comments

[Vincent]

Thanks for the info! Really helped to clear things up for me. I don't think I'll be using a credit card at all in the future, seems like they've figured out how to scam you every which way.