An interest rate is not everything there is to know about how interest and charges are earned or levied on an account. Beyond the numbers, knowing how interest is calculated is crucial, especially on items such as credit cards and bank accounts. Some methods of calculation may result in higher-than-expected fees than others on the same set of transactions. The Adjusted Balance method is one of the most common methods used in credit card interest and fee calculations.
Adjusted Balance Method
The Adjusted Balance Method is a way of calculating fees, charges or interest on an account. It is unusual in that it is based on the balance in an account after it has been adjusted by payments (in the event of a credit account) or withdrawals (in the event of a bank account). This often results in a lower fee, charge or interest amount than other methods, such as the Average Balance or the Average Daily Balance Methods as it allows for adjustments before calculations are made and is not based solely on activity throughout the billing or earning cycle.
Example of Adjusted Balance Method
A credit card has a balance of $100 at the beginning of the month. Charges of $150 are made to the card throughout the billing cycle. A $200 payment is made to the credit card, reducing the balance to $50 by the end of the billing period. Using the adjusted balance method, only the $50 that remains at the close of the billing cycle is subject to interest (and any finance fees).
Average Balance Method
The Average Balance method is another means of calculating interest or fees; however, as the name implies, it uses the average balance rather than the closing balance on an account. This can result in a higher balance subject to interest or fees than when using the Adjusted Balance Method.
Example of Average Balance Method
If an account has a balance of $100 at the beginning of the month (or billing cycle) and $50 at the end, the average balance would be $75. Interest and fees would be applied on that amount.
Average Daily Balance
The Average Daily Balance method is yet another method of calculating interest on an account. Like its name suggests, it takes the average balance at the end of each day throughout the billing (or earning) cycle. This means that any payments made throughout a day will reflect the balance used in calculations, but that a balance of zero at the end of a month may still be subject to interest due to the fact that some days in the month had a non-zero balance.
Example of Average Daily Balance Method
A bank account has a balance of $200 for 29 days of a month. On the 30th day, $200 was withdrawn. The total of all charges would be ($200 x 29 days) + ($0 x 1 day), or $5,600. The average over the 30 days, then, would be $193 ($5,600/30). Interest would be earned (or charged) on this amount rather than on the zero balance at the end of the month. In the event of a credit card, the $193 would then be multiplied by the daily APR percentage.
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