What Is the Previous Balance Method?

The previous balance method is used in finance and accounting to calculate costs and interest based on the amount owed from the previous billing cycle. For a credit card account, the interest rate is applied to the outstanding balance from the previous billing period to determine the current finance charge. Payments and charges made during the current billing cycle are not included in the calculation. The previous balance method typically results in higher finance charges than the adjusted balance method, and lower charges than average daily balance calculations.

This accounting technique is often seen as favoring the credit issuer. Basing an account's finance charges on the previous month's outstanding balance can result in interest being charged on a balance even after it has been paid down. By not including charges from the current period, however, the previous balance method assures that there will be no new finance charges incurred until the end of the billing cycle. Typically, this gives consumers a 30-day window to pay off new purchases without the assessment of a finance charge.

For example, consider an account that had an outstanding balance of 1000 monetary units at the end of a billing cycle. Assume that during the current period a 100 unit payment and a 50 unit purchase was made. At the end of the current period, the account would have an outstanding balance of 950 units. Using the previous balance method, the finance charge would be calculated on the prior month's ending balance of 1000 units, however. If the annual percentage rate was 12%, the periodic rate would be 1% and the finance charge would be 1000 * 0.01 = 10 units.

Unlike the previous balance method, the adjusted balance method is seen as favoring the consumer. This method accounts for all payments and purchases made during the current billing cycle. The account balance at the end of the current cycle is the basis for calculating finance charges. If an account entered the current billing period with a 1000 monetary unit balance, made a 100 unit payment and a 50 unit purchase, the ending balance would again be 950 units. The finance charge, calculated at the above rate, would be 950 * 0.01 = 9.5 units, however.

Retail stores commonly use the average daily balance method to calculate charges for their accounts. Any outstanding balance is calculated at the end of each day. Charges are added and payments subtracted as they occur. At the end of the billing period, the daily totals are averaged with the result serving as the base for calculating finance charges. While this method can lower charges for a given rate, department stores normally charge a much higher rate of interest than bank issued cards.