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The adjusted balance method is a particular way of calculating interest on a financial account. This covers both interest charged to a borrower and interest paid to a saver. The method involves making a single interest calculation at the end of each period and can produce significantly different results from other methods.
Calculating interest charges or payments using the adjusted balance method is comparatively simple. It works based on the interest charge cycle, for example, once a month with an account that has a monthly billing cycle. The calculation involves starting with the closing balance from the previous period, subtracting any payments or credits that were received by the bank during the period, then using this final balance to work out the charge for the month.
The key to adjusted balance method is that the interest calculation at the end of a billing cycle does not account for any new spending during that billing cycle. It is based solely on the previous closing balance and any repayments in the meantime. The practical effect is that if the customer makes a purchase but repays the money before the end of the current billing cycle, he will not be charged any interest on that purchase. This system is the basis of the "interest free period" on many credit cards.
One point which can be missed with an adjusted balance method is that it often does not take account of any interest charges applied during the cycle. This means that the interest charge worked out at the end of January does not affect the figures used to create the interest charge at the end of February and so on. This tends to mean the method produces lower charges.
There are several variations on the adjusted balance method that work on a similar principle but with slightly different details. Previous balance is based solely on the balance at the end of the previous cycle, meaning neither new spending nor repayments during the current cycle affect the new interest charge. Two-cycle balance works by taking the balance from two months ago and taking account of payments since that date; the practical effect is that customers can only get an interest free period if they always pay off spending in full by the due date.
The most common method, average daily balance, works in a completely different way. It means the bank keeps track of the account balance at the end of each day during the cycle, then calculates an average balance at the end of the cycle. This balance is used to calculate the interest charge for the entire cycle. This can mean higher interest charges, though on the other hand people who pay off bills in advance of the due date will benefit.