The average balance refers to the average amount of money contained in an account over a given period of time. The number is determined by the amount of money in an account and the time period in question. The average balance is used for a number of different purposes, most notably to calculate the amount of credit card interest accrued in a set period of time.
Like any other average, the average balance is calculated by adding up the different amounts in the account and dividing that number by the period in question. For example, if an individual wanted to calculate the average daily balance over a five day period, he would add up the balance on day one, day two, day three, day four, and day five. You would then divide by five, since this is the number of days in question.
The average balance can be calculated over any period of time. Assume, for example, that someone had a credit card on which she owed $100 US Dollars (USD) the first month, $95 USD the second, $85 USD the third, $75 USD the fourth, $50 USD the fifth, $20 USD the sixth, and $0 USD for the rest of the year. Her average balance over the course of the year would be equal to (100+95+85+75+50+20+0+0+0+0+0+0)/12. This means the average annual balance on that credit card would be equal to approximately $35.42 USD.
Credit card companies often use the average daily balance in order to determine the monthly interest rate to assess. The company adds up the amount the cardholder owes each day throughout the month. They then divide this total number by the number of days in the month in order to determine the average daily balance.
Interest is then calculated based on the average daily balance. So, if an average daily balance was determined to be $100 USD, the credit card company would multiply this average daily balance by the account's interest rate to determine the amount of interest owed for that month. This process would then be repeated each month, based on the average daily balance calculations for that given month.
Average daily balance can also be calculated on a bi-monthly basis or a yearly basis. Credit card companies have also used a practice called double-cycle billing, which means that the interest rate is calculated based on the previous two months' average daily balance. In the US, the Fair Credit Practice laws put an end to double cycle billing, however.