What is the Average Daily Balance Method?

The average daily balance is a common accounting method that calculates interest charges by considering the balance invested or owed at the end of each day of the billing period, rather than the balance invested or owed at the end of the week, month, or year.

Understanding the Average Daily Balance Method

The federal Truth-In-Lending-Act (TILA) requires lenders to disclose their method of calculating finance charges, as well as annual percentage rates (APR), fees, and other terms, in their terms and conditions statement. Providing these details makes it easier to compare different credit cards.

TILA permits the interest owed on credit card balances to be calculated in various different ways. The most common methods are:

• Average daily balance method: Uses the balance on each day of the billing cycle, rather than an average balance throughout the billing cycle, to calculate finance charges.
• Previous balance method: Interest charges are based on the amount owed at the beginning of the previous month’s billing cycle.
• Adjusted balance method: Bases finance charges on the amount(s) owed at the end of the current billing cycle after credits and payments have been posted.

How the Average Daily Balance Method Works

The average daily balance totals each day’s balance for the billing cycle and divides by the total number of days in the billing cycle. Then, the balance is multiplied by the monthly interest rate to assess the customer’s finance charge—dividing the cardholder’s APR by 12 calculates the monthly interest rate. However, if the lender or card issuer uses a method that compounds interest daily, the interest associated with the day’s ending balance gets added to the next day’s beginning balance. This will result in higher interest charges and the reader should confirm which method is being used.

The average daily balance credits a customer’s account from the day the credit card company receives a payment. To assess the balance due, the credit card issuer sums the beginning balance for each day in the billing period and subtracts any payments as they arrive and any credits made to the customer’s account that day.

Cash advances are usually included in the average daily balance. The total balance due may fluctuate daily because of payments and purchases.

Average Daily Balance Method Example

A credit card has a monthly interest rate of 1.5 percent, and the previous balance is $500. On the 15th day of a billing cycle, the credit card company receives and credits a customer’s payment of $300. On the 18th day, the customer makes a $100 purchase.

The average daily balance is ((14 x 500) + (3 x 200) + (13 x 300)) / 30 = (7,000 + 600 + 3,900) / 30 = 383.33. The bigger the payment a customer pays and the earlier in the billing cycle the customer makes a payment, the lower the finance charges assessed. The denominator, 30 in this example, will vary based on the number of days in the billing cycle for a given month.

Average Daily Balance Method Vs. Adjusted Balance Method Vs. Previous Balance Method

Interest charges using the average daily balance method should be lower than the previous balance method, which charges interest based on the amount of debt carried over from the previous billing cycle to the new billing cycle. On the other hand, the average daily balance method will likely incur higher interest charges than the adjusted balance method because the latter bases finance charges on the current billing period’s ending balance.

Card issuers use the adjusted balance method much less frequently than either the average daily balance method or the previous balance method.

Special Considerations

Some credit card companies previously used the double-cycle billing method, assessing a customer’s average daily balance over the last two billing cycles.

Double-cycle billing can add a significant amount of interest charges to customers whose average balance varies greatly from month to month. The Credit CARD Act of 2009 banned double-cycle billing on credit cards.

What Is Annualization?

To annualize a number means to convert a short-term calculation or rate into an annual rate. Typically, an investment that yields a short-term rate of return is annualized to determine an annual rate of return, which may also include compounding or reinvestment of interest and dividends. It helps to annualize a rate of return to better compare the performance of one security versus another.

Annualization is a similar concept to reporting financial figures on an annual basis.

Understanding Annualization

When a number is annualized, it’s usually for rates of less than one year in duration. If the yield being considered is subject to compounding, annualization will also account for the effects of compounding. Annualizing can be used to determine the financial performance of an asset, security, or company.

When a number is annualized, the short-term performance or result is used to forecast the performance for the next twelve months or one year. Below are a few of the most common examples of when annualizing is utilized.

Company Performance

An annualized return is similar to a run rate, which refers to the financial performance of a company based on current financial information as a predictor of future performance. The run rate functions as an extrapolation of current financial performance and assumes that current conditions will continue.

Loans

The annualized cost of loan products is often expressed as an annual percentage rate (APR). The APR considers every cost associated with the loan, such as interest and origination fees, and converts the total of these costs to an annual rate that is a percentage of the amount borrowed.

Loan rates for short-term borrowings can be annualized as well. Loan products including payday loans and title loans, charge a flat finance fee such as $15 or $20 to borrow a nominal amount for a few weeks to a month. On the surface, the $20 fee for one month doesn’t appear to be exorbitant. However, annualizing the number equates to $240 and could be extremely large relative to the loan amount.

Tax Purposes

Taxpayers annualize by converting a tax period of less than one year into an annual period. The conversion helps wage earners establish an effective tax plan and manage any tax implications.

For example, taxpayers can multiply their monthly income by 12 months to determine their annualized income. Annualizing income can help taxpayers estimate their effective tax rate based on the calculation and can be helpful in budgeting their quarterly taxes.

Example: Investments

Investments are annualized frequently. Let’s say a stock returned 1% in one month in capital gains on a simple (not compounding) basis. The annualized rate of return would be equal to 12% because there are 12 months in one year. In other words, you multiply the shorter-term rate of return by the number of periods that make up one year. A monthly return would be multiplied by 12 months.

However, let’s say an investment returned 1% in one week. To annualize the return, we’d multiply the 1% by the number of weeks in one year or 52 weeks. The annualized return would be 52%.

Quarterly rates of return are often annualized for comparative purposes. A stock or bond might return 5% in Q1. We could annualize the return by multiplying 5% by the number of periods or quarters in a year. The investment would have an annualized return of 20% because there are four quarters in one year or (5% * 4 = 20%).

Special Considerations and Limitations of Annualizing

The annualized rate of return or forecast is not guaranteed and can change due to outside factors and market conditions. Consider an investment that returns 1% in one month; the security would return 12% on an annualized basis. However, the annualized return of a stock cannot be forecasted with a high degree of certainty using the stock’s short-term performance.

There are many factors that could impact a stock’s price throughout the year such as market volatility, the company’s financial performance, and macroeconomic conditions. As a result, fluctuations in the stock price would make the original annualized forecast incorrect. For example, a stock might return 1% in month one and return -3% the following month.