How Is Interest Charged on Most Lines of Credit?
A line of credit (LOC) is a form of a flexible, direct loan between a financial institution—usually a bank—and an individual or business. Like credit cards, lines of credit have predetermined borrowing limits, and the borrower can draw down on the account at any time, provided the limit is not exceeded.
Also, like credit cards, lines of credit tend to have relatively high interest rates and some annual fees, but interest is not charged unless there is an outstanding balance on the account.
- A line of credit (LOC) will give you access to loaned money if and when you need it and may be either secured—such as a home equity line of credit (HELOC)—or unsecured—such as a credit card.
- Interest charges on LOCs usually use a simple interest method (as opposed to compound interest).
- The average daily balance used is often arrived at using 1/365th or 1/360th multiplied by the days in the billing period.
Lines of Credit
Lines of credit have the same features as revolving credit such as a credit card. A credit limit is established, and funds can be used for a variety of purposes. Interest is charged at regular intervals, and payments may be made at any time.
There is one major exception: The pool of available credit does not replenish after payments are made. Once you pay off the line of credit in full, the account is closed and cannot be used again.
As an example: Personal lines of credit are sometimes offered by banks in the form of an overdraft protection plan. A banking customer can sign up to have an overdraft plan linked to his or her checking account. If the customer goes over the amount available in checking, the overdraft keeps them from bouncing a check or having a purchase denied. Like any line of credit, an overdraft must be paid back, with interest.
Most lines of credit are unsecured loans. This means the borrower doesn’t promise the lender any collateral to back the LOC. One notable exception is a HELOC, which is secured by the equity in the borrower’s home. From the lender’s perspective, secured lines of credit are attractive because they provide a way to recoup the advanced funds in the event of non-payment.
Unsecured lines of credit tend to come with higher interest rates than secured LOCs. They are also more difficult to obtain and often require a higher credit score. Lenders attempt to compensate for the increased risk by limiting the number of funds that can be borrowed and by charging higher interest rates. That’s one reason why the APR on credit cards is so high. Credit cards are technically unsecured lines of credit, with the credit limit—how much you can charge on the card—representing its parameters.
Interest Calculation for Lines of Credit
Most lines of credit, even home equity lines of credit, use a simple interest method as opposed to compounding interest. Some lines of credit also demand loans that are structured to allow the lender to call the total amount due (including the interest) at any time for immediate repayment.
Interest on a line of credit is usually calculated monthly through the average daily balance method. This method is used to multiply the amount of each purchase made on the line of credit by the number of days remaining in the billing period. The amount is then divided by the total number of days in the billing period to find the average daily balance of each purchase. The average purchases are summed and added to any pre-existing balance, and then the average daily amount of payments on the account is subtracted. The leftover figure is the average balance, which is multiplied by the annual interest percentage rate (APR).
Interest rates are typically periodic rates that are calculated by dividing the APR by 360 or 365 days multiplied by the days in the billing period. There are many other ways interest is calculated and credited, but the majority of financial institutions use the methods above for lines of credit.