Credit Card Guide
What is an Average Daily Balance?
There are many methods by which credit card companies try to assess the finance charges on your account. One of these methods is known as the "average daily balance," which takes into account the total amount of money charged to your credit card on any given day that your account remains open.
The "average daily balance" is a term that represents an average day in the life of your credit card. Credit card companies use this determination in order to figure out what your finance charge should be by taking into account what your balance is on any given day within a specific period of time.
You already know that your new credit card will charge you a variety of interest charges and fees; how else will credit card companies stay in business? You may not know, however, how they determine what your finance charges could be.
Determining which credit card is right for you is not as easy as comparing the interest rates they charge. What you really need to look at is how a particularly credit card company determines what your rate is. Interest, or finance charges, is, of course, how credit card companies make money, but there is more than one way to assess what these charges will be. The most common one is known as the "average daily balance," which takes into account how much credit you charge to your card every single day for the entire duration of a billing cycle.
Average Daily Balance
The "average daily balance" system looks at your account activity over a period of time. While your contract might list a particular APR, your credit card company is not going to wait until the end of your contract year to charge you interest. Instead, they charge you daily by figuring out what the average balance of your account is every single day. This allows them to assess your finance charges according to every purchase you make as opposed to how much is left at the end of the month or year.
How It Works
In order to appreciate why this is the most common formula, you need to understand how it works. Basically, your credit card company will use several variables to determine how to calculate your finance charges:
- The beginning of your billing cycle
- The balance at the beginning of the cycle
- The balance at the end of the billing cycle
- The number of days spent at each new balance (after debits and credits)
- The number of days in the billing cycle
For example: For the first half of the month your balance is $500, but then on the 16th of the month you make another $500 purchase the "average daily balance" formula would be ($500 x 15 days) + ($1000 x 16 days) = 23500 / 31 days = $758 average daily balance.
Your credit card company will take this average daily balance amount and leverage it against your annual percentage rate in order to determine your interest, which is then assessed to you on your statement.
Basically, when using the average daily balance formula, the more time your account spends with high balance, the greater the finance charge is assessed. This is why financial consultants and planners will tell you that it is important to pay off your credit cards monthly, or at least try to pay your newest charges off as quickly as possible.
The average daily balance is the most common formula used to calculate credit card finance charges, and for good reason: it is perhaps the most accurate way to determine the behavior of a credit user during any given period of time.
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