The Average Daily Balance Method is a common technique used by financial institutions to calculate interest charges or interest income on financial products such as credit cards, loans, and savings accounts. This method takes into account the average balance in an account over a specific period, typically a billing cycle or a month.

Here’s how the Average Daily Balance Method is generally applied:

1. **Daily Balances:** For each day in the billing cycle or period, the outstanding balance of the account is recorded. This includes any new purchases, payments, or withdrawals made during the day.

2. **Calculation of Daily Average:** The sum of the daily balances is divided by the number of days in the billing cycle to calculate the average daily balance. The formula is:

\[ \text{Average Daily Balance} = \frac{\text{Sum of Daily Balances}}{\text{Number of Days in Billing Cycle}} \]

3. **Application to Interest Calculation:** The average daily balance is then used as the basis for calculating interest charges on credit cards or interest income on savings accounts or loans. The interest is usually calculated on a daily basis and then aggregated for the entire billing cycle.

For example, let’s consider a credit card with the following daily balances during a billing cycle:

– Day 1: $1,000
– Day 2: $1,200
– Day 3: $900
– …

If the billing cycle is 30 days, the Average Daily Balance would be calculated as:

\[ \text{Average Daily Balance} = \frac{(1,000 + 1,200 + 900 + \ldots)}{30} \]

This average is then used in the interest calculation.

The Average Daily Balance Method is considered a fair and more accurate way of calculating interest compared to other methods, such as the Simple Daily Interest Method, which doesn’t consider the daily fluctuation in balances. It provides a closer approximation of the actual amount of money the account holder had in the account on average during the billing cycle.

It’s important for account holders to understand the method used by their financial institution, especially when it comes to credit cards, as it can have a significant impact on the amount of interest charged. For savings accounts or loans, the Average Daily Balance Method is also used to calculate interest earned or paid.