When you use money given out by a lender, you pay interest. It represents the cost of using the credit facility. Most consumers are concerned about how interest is charged to determine if the lender is using the appropriate approach. So how is line of credit interest calculated?
This article will show you the basis for interest calculation on line of credit. We will also use examples to illustrate how the lender computes the interest.
How does line of credit interest work?
Before delving into interest computations, it’s important to know about these key features of a line of credit.
- Borrowing limit: It represents the amount available to be drawn by the borrower. It’s also referred to as the credit limit.
- Balance: It’s the amount that has been issued to you or the amount owed. Balances may be carried over to the next billing period.
- Payments: Payments are the sums of money you pay to the lender to decrease your balance.
- Minimum payment: The lender may specify the minimum amount of money they expect you to pay if you have an outstanding balance at the end of each billing cycle.
- Billing cycle: It’s simply the period before you receive your next bill for your credit usage. Most LOCs and loans have monthly billing cycles.
- Annual interest rate (APR): The APR represents the interest charged for the whole year.
Now that we have defined these terms, let’s examine two main ways of charging interest.
Simple interest vs. Compound interest
Simple interest is in itself simple to understand and calculate! Basically, you compute the daily interest charged on the principal amount for the number of days you have taken out the credit facility.
The formula is expressed as:
Interest = (Principal x daily interest x number of days)
With simple interest, the borrower pays interest only for the principal amount borrowed. The interest is not added to the principal amount.
On the other hand, compound interest involves compounding interest from previous billing periods into the principal amount. Essentially, the borrower pays interest for the interest that has accumulated from previous billing periods.
How is interest calculated on a line of credit?
Most lenders use simple interest. This interest is calculated based on the daily balance and not the monthly balance. We can quickly illustrate this difference using an example.
Example: Assume that you are borrowing a line of credit with the following terms:
LOC A:
Credit limit | $1000 |
Annual Percentage Rate (APR) | 20% |
Interest type | Daily |
Billing period | Monthly |
LOC B
Credit limit | $1000 |
Annual Percentage Rate (APR) | 20% |
Interest type | Monthly |
Billing duration | Monthly |
* For LOC A and LOC B, you plan to clear the balance at the end of the billing cycle. (at the end of the month).
Which LOC will be more expensive if you draw $500 with 15 days remaining in the billing cycle?
Well, for LOC A, we find out the interest charged by first figuring out the daily periodic rate:
Daily periodic rate (DPR) = ( Annual percentage rate) / 365 days
DPR = 20%/365 = 0.05479%
Next, we calculate the interest for the number of days.
We will have an outstanding balance for 15 days since we made a withdrawal with 15 days remaining on the billing period.
Number of days with balance = 15 days
LOC A total interest = (15 days x 0.05479 x $500)/100 = $4.1
* The interest is charged on the amount drawn only. Lenders only charge you for the number of days you have an outstanding balance.
For LOC B, the interest is charged monthly for the total outstanding balance. The calculation is as follows:
Monthly interest rate = 20% / 12 = 1.667%
LOC B total interest = (1.667%x $500)/100 = $8.335
When the interest is calculated for the number of days we have the balance, it’s undoubtedly cheaper than if it’s applied monthly regardless of the number of days you have had the balance.
Interest calculation on line of credit – Using the average daily balance
It’s more likely that you may make multiple withdrawals on your line of credit in real life. Remember that the lender will charge interest daily based on the amount owed. That’s where the average daily balance method comes in, and it’s based on determining the average balance on each day of the billing cycle.
Let’s explain this using an example:
The annual percentage on the credit line is 25%, and the credit limit is $1500. Assume that the activities on that account are as follows for the month of June:
Balance at the beginning of the month | $600 |
First Month Draw 15th day | $250 |
Payment made on the 17th day | $400 |
Second Month Draw 23 day | $150 |
So, how much interest will be due?
Well, the finance charge will be calculated by multiplying the monthly interest rate by the average daily balance.
It’s the same as multiplying the daily periodic rate by the average daily balance and dividing the sum by the number of days in the billing period.
In this example, we need to find the average daily balance. We do this as follows:
Days | Balance | (Days x Balance) |
14 – Up to 15th | $600 | 8400 |
2 – Up to 17th | $850 | 1700 |
6 – Up to 23th | $450 | 2700 |
8 – Up to 30th | $550 | 4400 |
Total | 17200 | |
Daily average balance | Divide by 30 days | $573.33 |
Interest for the billing cycle:
Daily periodic rate = 25%/365 = 0.068%
We multiply the DPR by Number of days in the billing period
= 0.068% x 30 days = 2.05%
The interest payment = ($574.33 x 2.05%)/100 = $11.77
Notes:
- Lenders will mostly use the average daily balance to calculate the interest to charge.
- It takes into account any outstanding balance carried over into the current period from the previous month.
- You will not be expected to pay the principal at the end of the month.
- The lender may have a minimum payment that may be stated as a percentage of the outstanding balance or a fixed rate minimum.
- Clearing the outstanding balance means that you have less interest to pay.
Additional fees that are charged for a line of credit
Borrowers can also expect additional fees that are charged for a line of credit or HELOC. Some lenders may have monthly or annual fees.
If you attempt to pay off the debt using a check or automatic debit, but it fails, you can expect to pay the penalty for insufficient funds, up to $40.
Similarly, if you go over your credit limit, the lender may charge an over the credit limit fee. Fees may be imposed for ordering an extra copy of your monthly statement from the lender. Additionally, there may be setup fees in the beginning.
Final word
Now, you know all about: how is interest calculated on a line of credit. Most lenders will use the simple interest and the average daily balance to compute the interest amount. Any additional fees may increase the finance charge, so evaluate the extra fees.
Also, consider if the credit limit is replenished after you make payments to pay down the balance. In most cases, the credit line will expire after you exhaust the credit facility and pay off outstanding balances.