The fairest method for calculating interest on an account used __ method for determining the balance to which the interest rate is applied.
Select one: a. minimum-balance b. quarterly compounding c. average daily balance d. APY
The correct answer and explanation is:
The correct answer is c. average daily balance.
Explanation:
When calculating interest on an account, the average daily balance method is considered the fairest because it takes into account the fluctuations in the account balance over a specific period, such as a month. This method works by calculating the daily balance of an account for each day in the billing cycle, then averaging these daily balances. The resulting average is the balance on which the interest rate is applied.
This method is widely used because it reflects the actual amount of money available in the account throughout the period, rather than using the balance at a single point in time, such as the minimum balance or the balance at the end of the month. By using the average daily balance, account holders are charged interest based on the balance they maintained on average over the entire period, which is generally seen as a more accurate and equitable approach.
In contrast, the minimum-balance method could be unfair, as it uses the lowest balance in the account, potentially applying interest to a smaller amount than the account holder had available for most of the period. Quarterly compounding refers to the frequency at which interest is compounded, not to the method of calculating the balance. The APY (Annual Percentage Yield), while useful for comparing interest rates, does not describe the method for calculating interest on an account directly.
The average daily balance method is also more consistent with the way financial institutions handle accounts with varying daily balances, and it accounts for deposits and withdrawals throughout the month. Therefore, it provides a more accurate reflection of how much money was available for interest accrual over time.