How to Calculate Average Outstanding Balance: Impact on Credit Scores and Interest Charges

What is Average Outstanding Balance?

The average outstanding balance is a financial metric that reflects the average amount of debt you owe over a given period. It includes various types of debt such as term loans, installment loans, revolving credit (like credit cards), and other interest-bearing debts.

Types of Debt Included

This metric encompasses a wide range of financial obligations:

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• Term Loans: These are loans with fixed repayment terms, such as personal loans or auto loans.

• Installment Loans: These include mortgages and student loans.

• Revolving Credit: This category includes credit cards where you can borrow and repay funds repeatedly up to a certain limit.

• Other Interest-Bearing Debts: Any other debt that accrues interest over time.

Understanding which debts are included helps you get a comprehensive view of your financial obligations.

How to Calculate Average Outstanding Balance

Calculating the average outstanding balance can be done using two common methods: daily or monthly calculations.

Daily or Monthly Calculation

Example: John’s Personal Loan

Let’s consider John who has a personal loan with a principal amount of $10,000 over 12 months. Here’s how you might calculate his average outstanding balance:

1. Monthly Balances:

   • Month 1: $10,000

   • Month 2: $9,500 (after paying $500)

   • Month 3: $9,000 (after paying another $500)

   • …

   • Month 12: $0 (fully paid)

2. Average Monthly Balance:

   • Add all monthly balances: $10,000 + $9,500 + … + $0 = $60,000

   • Divide by the number of months: $60,000 / 12 = $5,000

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So, John’s average outstanding balance for the year would be $5,000.

Average Daily Balance Method

Credit card issuers often use this method to calculate interest charges.

Formula and Example

For example:

• Suppose you have a credit card with an initial balance of $2,000 at the start of the billing cycle.

• During the cycle, you make purchases totaling $1,500 and then pay off $1,000.

• The daily balances would be calculated as follows:

  • Day 1-15: $2,000

  • Day 16-30: $2,500 ($2,000 + $1,500)

  • Day 31-45: $1,500 ($2,500 – $1,000)

1. Calculate Daily Balances:

   • Sum all daily balances: (15 days * $2,000) + (15 days * $2,500) + (15 days * $1,500) = $30,000 + $37,500 + $22,500 = $90,000

   • Divide by the number of days in the billing cycle (45): $90,000 / 45 ≈ $2,000

This gives you an average daily balance of approximately $2,000.

Impact on Credit Scores

Your average outstanding balance plays a significant role in determining your credit score.

Reporting to Credit Bureaus

Each month, lenders report your outstanding balances to credit bureaus. These reports are used to calculate your credit utilization ratio and overall credit score.

Factors Affecting Credit Scores

Two key factors influenced by your average outstanding balance are:

• Timeliness of Payments: Consistently making payments on time helps improve your credit score.

• Credit Utilization Ratio: Keeping total outstanding balances below 30% of available credit is highly recommended. For instance, if you have a credit limit of $10,000 on all cards combined, try to keep your total balance below $3,000.

Risk of Default

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Large outstanding balances can indicate financial trouble and increase the risk of default. This can negatively affect your access to future credit.

Impact on Interest Charges

The method used to calculate interest can significantly impact how much you pay.

Interest Calculation Methods

There are several methods lenders use:

• Average Daily Balance Method: As explained earlier.

• Beginning Balance Method: Interest is calculated based on the balance at the beginning of the billing cycle.

• Adjusted Balance Method: Interest is calculated after subtracting any payments made during the cycle.

Example Calculation

Using the average daily balance method from our previous example:

If your average daily balance is $2,000 and your annual percentage rate (APR) is 18%, here’s how interest would be calculated:

[ \text{Interest Charge} = \frac{\$2,000 \times 18\%}{365} \times 30 \approx \$29.59 ]

Strategies to Reduce Interest

To minimize interest charges:

• Make payments early in the billing cycle.

• Delay purchases until later in the cycle.

• Pay more than the minimum payment each month.

Practical Applications and Financial Planning

Managing your average outstanding balance is crucial for both personal and business financial health.

Financial Health

Keeping track of these balances helps you understand where you stand financially. It allows you to identify areas where you can cut back or allocate funds more efficiently.

Budgeting and Planning

Understanding these balances aids in financial planning by helping you manage debt effectively. Here are some tips:

• Create a budget that accounts for all debts.

• Prioritize high-interest debts first.

• Consider consolidating debts into lower-interest loans or credit cards.

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