How Does the Interest on a Line of Credit Work?

A line of credit is a flexible borrowing option that allows individuals or businesses to access funds as needed, up to a set limit. Unlike traditional loans, where borrowers receive a lump sum and start paying interest immediately, a line of credit accrues interest only on the amount borrowed. This makes it useful for managing cash flow, covering unexpected expenses, or funding ongoing projects.

Understanding how interest is calculated helps borrowers minimize costs and make informed financial decisions.

Common Calculation Methods

Lenders use different methods to determine interest, which affects the total cost of borrowing. The three primary methods are daily balance, average daily balance, and monthly balance.

Daily Balance

This method calculates interest based on the outstanding principal at the end of each day. The daily interest rate is determined by dividing the annual interest rate by 365. The lender applies this rate to the balance, and unpaid interest may be added to the principal, leading to compounding.

For example, with an annual interest rate of 10%, the daily rate is approximately 0.0274% (10% ÷ 365). If a borrower has a $5,000 balance, the daily interest charge is $1.37 ($5,000 × 0.0274%). Over 30 days, assuming no payments, the borrower accrues about $41 in interest. Since interest is calculated daily, making payments sooner reduces costs.

Average Daily Balance

This method calculates interest based on the sum of daily balances divided by the number of days in the billing cycle. It benefits borrowers who make frequent payments, as reducing the balance earlier in the cycle lowers interest charges.

For example, if a borrower has a $10,000 line of credit with the following balances:

– Days 1-10: $4,000
– Days 11-20: $6,000
– Days 21-30: $5,000

The average daily balance is:

(4,000 × 10) + (6,000 × 10) + (5,000 × 10) ÷ 30 = (40,000 + 60,000 + 50,000) ÷ 30 = 5,000

With a 12% annual interest rate, the monthly rate is 1% (12% ÷ 12). The interest charge for the period is $50 ($5,000 × 1%).

Monthly Balance

This method applies interest to the balance at the end of the billing cycle. The lender calculates interest using the monthly rate, which is the annual rate divided by 12.

For instance, if a borrower has a $7,000 balance at the end of the cycle and the annual interest rate is 15%, the monthly rate is 1.25% (15% ÷ 12). The interest charge is $87.50 ($7,000 × 1.25%). Unlike the daily balance method, mid-cycle payments do not reduce the interest for that period.

Fixed and Variable Rates

The type of interest rate affects borrowing costs. Fixed rates remain unchanged for a set period, providing predictable payments. This can be beneficial when rates are expected to rise, but they often start higher than variable rates.

Variable rates fluctuate based on a benchmark, such as the prime rate or the Secured Overnight Financing Rate (SOFR). Lenders add a margin to the benchmark, meaning the total rate adjusts periodically. If rates drop, borrowers pay less interest, but rising rates increase costs.

Some lenders offer hybrid structures, where part of the balance has a fixed rate while the rest remains variable. Others allow borrowers to convert a variable-rate balance into a fixed-rate loan.

Billing Cycle and Compounding

A line of credit operates within a billing cycle, typically 28 to 31 days, which determines when interest is applied and payments are due. Lenders issue statements at the end of each cycle, detailing the balance, interest charges, and minimum payment. Missing a payment can result in penalties or a reduced credit limit.

Compounding increases borrowing costs, as unpaid interest is added to the principal. Some lines of credit use simple interest, where charges apply only to the original borrowed amount, but many incorporate compounding. The frequency varies by lender, with some compounding daily and others monthly. More frequent compounding increases total interest costs.

Draw Amounts and Interest Charges

Borrowers access funds by drawing specific amounts, and lenders may impose minimum draw requirements. For example, a lender might require a minimum withdrawal of $500 per transaction, which affects borrowing strategies for those needing smaller amounts. Some lenders also limit the number of draws per billing cycle.

Interest begins accruing as soon as funds are drawn. Some lines of credit offer interest-only payment periods, where borrowers pay only the accrued interest for a set time before transitioning to full principal and interest payments. While this provides short-term cash flow relief, it increases long-term costs if the principal remains unpaid.

Payment Structure

Repayment terms vary by lender. Some lines of credit require only minimum payments, covering just the interest or a small percentage of the balance. While this keeps payments low, it extends the repayment period and increases total interest paid. Others require fixed monthly payments that include both principal and interest, reducing the balance over time.

Some lines of credit feature balloon payments, where borrowers make smaller payments throughout the term but must repay the remaining balance in full at the end. This can be useful for those expecting future income but risky if repayment becomes unmanageable. Automatic payment options help borrowers avoid missed payments and penalties.

Additional Fees

Beyond interest, lines of credit often come with fees. Some lenders charge annual maintenance fees, which can range from $50 to several hundred dollars, regardless of usage. Transaction fees may apply for each withdrawal, particularly for business lines of credit or those linked to overdraft protection.

Late payment fees can be a flat amount or a percentage of the overdue balance. Some lenders charge inactivity fees if the credit line remains unused for a long period. Prepayment penalties, though less common, may apply if a borrower repays the balance early. Reviewing these fees helps borrowers understand the full cost of maintaining a line of credit.