The average outstanding balance on credit cards refers to the unpaid, interest-bearing balance averaged over a pre-defined period. This metric is crucial for both consumers and financial institutions as it indicates the amount of debt carried regularly and influences interest calculations.
Calculation Methods
Daily Balance Method
One way to calculate the average outstanding balance is the daily balance method. Here, the sum of the unpaid balances on the account each day during the billing cycle is divided by the number of days in the cycle.
Formula:
Monthly Balance Method
Alternatively, some institutions use a monthly average. This involves summing the month-end balances over a given period (usually 12 months) and dividing by the number of months.
Formula:
Special Considerations
Interest Calculation: The average outstanding balance is vital for computing interest charges. Higher average balances result in higher interest payments.
Credit Score Impact: It affects credit utilization ratios, a key factor in credit scores. Higher average balances can negatively impact credit scores.
Historical Context
The concept of average outstanding balance gained prominence with the evolution of credit card usage in the latter half of the 20th century. As credit cards became a common financial tool, both consumers and financial institutions sought more accurate ways to measure and manage revolving debt.
Applicability and Examples
Practical Example
Let’s assume a credit card has the following daily balances over a 30-day period:
- Days 1-10: $1,000
- Days 11-20: $500
- Days 21-30: $200
Using the Daily Balance Method:
Real-Life Scenario
For a year, a cardholder’s month-end balances were recorded as:
- $300, $500, $450, $400, $350, $600, $550, $500, $400, $450, $500, $600
Using the Monthly Balance Method:
Comparisons and Related Terms
Credit Utilization Ratio
This term refers to the percentage of credit used relative to the credit limit available. Calculating the average outstanding balance helps in determining one’s credit utilization ratio over a period.
APR (Annual Percentage Rate)
The average outstanding balance significantly impacts the Annual Percentage Rate (APR) on a revolving credit account, influencing the total interest paid.
Frequently Asked Questions (FAQs)
How does the average outstanding balance affect my credit score?
It affects the credit utilization ratio, a significant component of credit scores. Lower average balances relative to your credit limit generally result in a better credit score.
Why do credit card companies use average balances?
They use average balances for consistency and accuracy in calculating interest charges, reflecting daily usage patterns better than a single point-in-time balance.
Can I reduce my average outstanding balance?
Yes, you can reduce your average outstanding balance by paying off your debt consistently, avoiding large purchases near the end of the billing cycle, and ensuring you don’t carry a balance month to month.
References
- Federal Reserve’s Consumer Credit Report
- FICO’s Credit Utilization Insights
- “Credit Card Management” by Robert M. Lawrence
Summary
Understanding the average outstanding balance on credit cards provides valuable insights into one’s financial health. By grasping the calculation methods, implications, and ways to manage it, consumers can make informed decisions, improve their credit scores, and minimize interest payments.
