Home Business Insights & Advice How is interest charged on most lines of credit?

How is interest charged on most lines of credit?

by John Saunders
4th Nov 19 11:05 am

When running a business, a line of credit is important in that it assists you in meeting short term project needs. It works almost like a credit card in that you borrow only the amount you require for a particular project. Charging for the line of credit differs from one institution to another but most of them use the average daily balance method.

What is a line of credit?

This is a revolving credit account that allows you to borrow funds from a lending institution. Like credit cards, it has a loan limit. It therefore means that you cannot borrow past a certain amount as set by the institution. However, it differs from a loan in that as the latter gives you a lump sum, line of credit gives you money only when you purchase. A loan of credit is appropriate for short term borrowing. So far, there is no established formula for the calculation of the amount of interest payable for a line of credit. Therefore, lenders are the sole determinant of the payment size and they base it on interest rate, line of credit terms, and the outstanding balance.

Home equity line of credit (HELOC) is the most common line of credit available. In this case, you use your house as collateral on the amount borrowed, as opposed to the credit cards where they are unsecured. However, it is risky in that failure to pay the HELOC might end you up homeless. Generally, the equity set on the lines of credit is equal to the value of the house that you live in.

HELOCs gives you an opportunity to make a withdrawal of funds from the line of credit for a certain set period regarded as draw period. In the end, you have two options after the draw period. First, you can renew your line of credit; make an immediate payment of principal and the outstanding balance. Secondly, you can start making regular payments on interest or principal over a set agreement from the institution, as it is with a loan or mortgage.

Line of credit interest rates

In order to calculate interest rates on HELOC, it is important to make a determination of the current line of credit rates of interest. Usually, the interest on a line of credit is variable which makes it difficult for determination. The rates however have their basis on a public index like the prime rate or U.S. Treasury bill rate. The rate you signed up for the HELOC might have changed by the time you begin making payments. In addition, some lenders may charge at a rate higher than the prime rate, which makes the credit expensive.

Your latest statement will determine your current rate but in case you cannot trace it, then the original paperwork will be used for payment. Thereafter, you can find the index utilised and make additions of the margins charged by the lending institution in order to know your rate. For instance, if the lender charges 2 percent, and the day’s rate is 9 percent, then your current rate would be 11 percent.

Calculating interest on the line of interest

Upon knowing your current interest rate, you can manually calculate the due interest or use the HELOC payment calculator. The interest for the month will be determined by the average daily balance and monthly charge. Most lines of credit utilises simple interest as opposed to compound interest. Therefore, you do not need to add each day’s interest to the next day balance.  In order to determine the average daily balance for you, checking your account is important. Add your daily balance from the previous month and then divide the given figure by the total number of days in the month.

The next task is to find the daily interest rate. Learn to use a daily line of interest calculator for easier process. However, you can also go manually by taking your current interest rate and diving it by 365 in order to determine the daily interest rate.

Consequently, for you to find the monthly interest, multiply the average daily interest by the daily rate of interest. The figure gotten in this case should be multiplied by number of days to get the monthly interest.

Conclusion

A line of credit is an essential tool that small businesses and individuals can utilise to grow themselves. These differ from both loans and credit cards as illustrated above. Therefore, it is important to understand the workings of these sort of loans in order to make rational decisions. Ultimately, using a line of credit is crucial and helps in sustaining businesses and projects.

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