A line of credit (LOC) is a form of a flexible, direct loanbetween 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.
Key Takeaways
- 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 1/365thor 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 ofavailable creditdoes 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 their 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 lenderany 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 highercredit 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 theAPRon credit cards is so high.Credit cardsare 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.
FAQs
In general, however, interest on a line of credit is calculated based on the balance you carry day-to-day. This means the more you borrow, and the longer you borrow it, the more interest you'll pay. Typically, the lender will take the annual interest rate and divide it by 365 to get the daily rate.
How is line of credit interest charged? ›
Usually, the interest rate on a line of credit is variable. This means it may go up or down over time. You pay interest on the money you borrow from the day you withdraw money, until you pay the balance back in full. Your credit score may affect the interest you'll pay on a line of credit.
What is a typical interest rate for a line of credit? ›
You might find rates ranging from 8 percent to 60 percent, depending on your credit score. The lower your credit score, the higher your overall cost of your business line of credit due to high interest rates and fees.
How do you avoid interest charges on a credit line? ›
Pay your monthly statement in full and on time
Paying the full amount will help you avoid any interest charges.
How do payments work on a line of credit? ›
The process of paying back the line of credit is simple. You pay back part or all of the capital borrowed from your line of credit at your own pace. However, you must repay the minimum payment shown on your monthly statement.
Do you pay interest on unused line of credit? ›
Lastly, while a credit card and a line of credit may have annual fees, neither charges interest until there is an outstanding balance.
Can you negotiate line of credit interest rates? ›
Negotiate the interest rate you have to pay. Be reasonable in your demands and prepared to go to a different bank if you can't get the rate you want. No bank will lend you money at less than the prime rate. Many will try to charge you prime plus 2%.
What is the monthly payment on a $50,000 home equity line of credit? ›
Assuming a borrower who has spent up to their HELOC credit limit, the monthly payment on a $50,000 HELOC at today's rates would be about $403 for an interest-only payment, or $472 for a principle-and-interest payment.
How do I calculate my line of credit interest? ›
The formula to calculate interest on a revolving line of credit is using an APR: (Balance x Interest Rate) x Days in Billing Period / 365 = monthly interest.
What is the monthly payment on a $75000 HELOC? ›
As of March 29, 2024, the average national rate for a 15-year loan was nearly the same as for a 10-year loan: 8.70%. With that rate and term, you'd pay $747.37 per month for the loan.
Cons: Variable interest rates can make budgeting challenging. Easy access to funds can tempt you to overspend. Late payments can result in fees and damage credit scores. Defaulting on secured lines of credit risks losing collateral.
How to save interest on line of credit? ›
Set up regular payments on your line of credit. Your monthly payments can be as low as interest only3, however paying more will reduce the balance sooner. Like a credit card, once you've paid off the outstanding balance your credit becomes available to use again.
Can you lock in an interest rate on a line of credit? ›
Getting a fixed rate lock option for a Home Equity Line of Credit (HELOChome equity line of credit) allows you to lock in a portion or all your balance at a fixed interest rate. Since this will remain the same for the duration of the loan, you'll be protected against any market fluctuations that might affect rates.
How does interest work on a line of credit? ›
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.
Can you pay off a line of credit early? ›
You can pay off your HELOC early, but be mindful of pre-payment fees, if any. If you have a Citizens HELOC, you're in luck as Citizens does not charge pre-payment fees. HELOCs allow you to make interest-only payments during the draw period, then transition to principal and interest payments during the repayment period.
How much is a monthly payment on a 25000 loan? ›
Advertising Disclosures
| Loan Amount | Loan Term (Years) | Estimated Fixed Monthly Payment* |
|---|
| $20,000 | 5 | $415.07 |
| $25,000 | 3 | $771.81 |
| $25,000 | 5 | $518.84 |
| $30,000 | 3 | $926.18 |
13 more rowsInterest on credit cards is generally charged on any balances that aren't paid by the due date each month. When you carry a balance from month to month, interest is accrued on a daily basis, based on what's called the Daily Periodic Rate (DPR).
How does a $10,000 line of credit work? ›
For example, if you have a credit line with a $10,000 limit, you can use part or all of it for whatever you need. If you carry a $5,000 balance, you can still use the remaining $5,000 at any time. If you pay off the $5,000, then you can access the full $10,000 again.
How do I find out my interest rate on line of credit? ›
The interest rate on your line of credit appears on your monthly account statements, which can be accessed directly in your online bank.
