How Is Interest Rate Calculated on Your Line of Credit?
Before you take on the financial burden of a credit line, be wise enough to check out details like loan amount, loan tenure, and most importantly, the rate of interest. Because the more clarity you have, the less anxious you will be while using a credit line.
Understand how credit lines work, the factors influencing their interest rate and how interest is calculated on a line of credit.
What is a line of credit (LOC)?
A line of credit is a type of loan that offers credit to people, companies, and other organisations so they may satisfy their financial demands on a personal and professional level. When allotted a credit line, individuals and businesses can borrow money up to a certain amount, pay back what they borrowed, and then borrow against the same limit without applying for a credit line again, provided the borrowed sum doesn’t go above the set limit. Every time a credit line is used, the borrowers are charged a fee in addition to interest on the amount borrowed.
There are two types of credit lines: Secured and Unsecured loans.
In contrast to an unsecured loan, which does not require any collateral, secured loans require you to reserve your asset as security. The interest rates can be reduced if your personal property is maintained as collateral since the lender can seize and take possession of your assets in case you don’t repay them. Home Equity Line Of Credit is an example of a secured loan. The rate of interest is low and fixed for the duration of the loan.
In unsecured loans, the interest rates are higher compared to secured loans since no collateral is demanded. These types of loans are provided solely based on your credit score which is your financial reputation. You can apply for credit lines like personal credit lines and business credit lines without providing any collateral.
The borrower is given a drawing term or a window of time during which money may be borrowed. You may be given a payment window after the draw time or are required to pay the whole amount you owe right away.
How is interest calculated on the line of credit?
For most credit lines, interest is calculated as per the simple interest method. But it is recommended to ask your credit issuer by what method your interest will be calculated.
Let’s say you borrowed a credit line of Rs 1,00,000 with an interest of 8%, you can either use an online interest calculator or do your maths yourself.
To get your average daily balance, tally up all of your daily balances from the previous month, then divide that total by the calendar month’s days.
Suppose you have an outstanding amount of Rs 80,000 at the beginning of the month, then Rs 5,000 was spent on July 8 and Rs 15,000 was spent on July 20. Your daily balance will be Rs 80,000 from July 1–7, Rs 85,000 from July 8–19, and Rs 100,000 from July 20–31.
Get your average monthly balance by multiplying Rs 80,000 by 7( July 1-7), Rs 85,000 by 12 (July 8-19), and then Rs 100,000 by the number of days remaining in the month i.e 12.
(80,000 X 7)+(85,000 X 12)+(100,000 X 12) = Rs 2,780,000
Divide your average monthly balance by 31 and you will get your average daily balance of Rs 89,677.42.
Find your daily interest rate by dividing your current interest rate by 365. Since your interest rate is 8%, your daily interest rate will be 0.0219%. By multiplying the daily interest rate by the average daily balance and then multiplying the answer by the number of days in that month.
You will get a daily interest payment that rounds up to Rs 20 (i.e 89,677.42 X 0.000219) and a monthly interest payment of Rs 620 (20 X 31 days).