Daily Balance vs. Avg. Daily Bal.

Can someone please explain the difference in the equations for computing interest using the daily balance method vs. avg. daily balance? We are conducting an interest audit and have discovered in our audit that accounts disclosed to be using the daily balance method appear to be using average daily balance method.

For a Daily Balance computation your system takes the ending balance in the account each day and computes the interest earned and at the end of the statement cycle it credits the account with the accrued interest. For Average Daily balance your computer sytem waits until the end of the statement cycle and averages the ending daily balances together and applies the interest rate towards that average balance and credits that to the customers account.

In my personal experience I have seen mostly the Daily balance method used to compute interest. Either way, if your system is computing it one way and the disclosure is stating it another way....you have a pretty big problem on your hands.

The daily balance method is going to accrue interest EACH DAY based on the balance in the account EACH DAY. The average daily balance will accrue interest at the end of the month based on the average balance for the month. Like Mac, I've generally seen the daily balance method used.

What trips folks up quite often, however, is disclosing that interest will accrue on the daily ledger balance, but paying interest based on the daily collected balance, or assessing a maintenance fee because the daily collected balance was less than a minimum, when the disclosures stated the fee would be waived if a particular daily ledger balance was maintained.

To specifically answer your question, you would divide the interest rate by the number of days in the year and apply that daily rate to the balance for each day in the period to recalculate the daily balance method, whereas you would multiply it (the daily rate) by the number of days in the period and apply that (the monthly rate) to the average balance for the period using the average daily balance method.