A revolving line of credit is a very useful tool. It can be used to pay down higher interest credit card debts, cover business expenses, or pay regular household bills. To use a line of credit (LOC) properly we should understand how it works, and how the interest is calculated.
At the time of set up a new LOC account will start with a balance of $0. Unlike a mortgage, car loan, or other amortized loan, the interest cost on a LOC is only calculated based on the amount of outstanding balance we use. This means if we don’t use the LOC we don’t pay any interest. 🙂
The interest rate on a LOC will typically range from 3% to 12% depending on the borrower’s credit history and their relationship with their banks. Interest is calculated on a daily basis on the amount of principal balance. For example, let’s say we borrow $1,000 on March 1st. Then on March 10th we pay down half of the debt, $500, and don’t do anything else for the rest of the month. In this case interest will be charged on the $1,000 for 10 days, and on $500 for the remaining 21 days of March. The interest amount will be accumulated and charged at the end of every month.
Using 5% interest rate as an example, we can calculate the cost of borrowing in the example above.
Interest cost from March 1st to March 10th = 0.05 x ($1000)*(10/365) = $1.37
Interest cost from March 11th to March 31st = 0.05 x ($500)*(21/365) = $1.44
We add the two amounts together to get $2.81. This is how much interest will be charged for the month of March. If we pay down the remaining $500 principal, and $2.81 interest balance on March 31st and do not borrow anymore, then there will be no interest charges in April.
Different Ways to Use LOCs
Since LOCs often have lower interest rates than credit cards we can transfer balance from a LOC to a credit card to save on interest costs. I also like to use my LOCs for emergency liquidity to pounce on a time sensitive investment opportunity or to cover a major car repair. I have also used a LOC in the past to pay down my student loans which was at a higher interest rate.
LOCs can be accessed through online banking. We can use it pay bills online, or send Interac e-Transfers. We can even order cheque books for our LOC accounts so we can write cheques to anyone. My regular chequing account only allows up to 10 free withdrawals every month. So sometimes I would use my LOC to cover some bill payments if I don’t want to exceed my chequing account limit. 😀
LOCs are also useful for developing credit history. It goes in the category of revolving credit. The more types of debt we have, the faster our credit score will climb. But of course borrowing too much can hurt our credit scores. Exceeding 50% credit utilization ratio is generally not recommended. The credit utilization ratio is calculated per debt category by credit bureaus. The best utilization ratio in order to maximize credit score is 0%. But practically speaking, a good ratio to maintain is less than 25%. So if we open 4 different LOC accounts at different banks, each with a $10,000 credit limit, then our total limit would be $40,000. We can borrow $8,000 from one, and keep a balance of $0 on the other LOCs. Doing so our total utilization ratio will only be 20%. ($8,000/$40,000)
Lines of Credit are very versatile, and can improve our financial flexibility. They’ve saved my butt a few times in the past when I made large purchases and didn’t have readily available savings. A LOC doesn’t cost anything if we don’t use it. But it can instantly turn into a much needed bridge loan, insurance policy, backup plan, or emergency payment when needed. Applying for a LOC at a bank is very straight forward. There are different types of LOCs such as a business LOC, home equity LOC (HELOC), personal unsecured LOC, etc. They all function the same way more or less, but generally you want to apply for the one that offers you the lowest interest rate. I think as a financial tool, LOCs deserve a lot more credit. 🙂
Random Useless Fact:
Studies show that close grandparent and grandchild relationships have healthy benefits.