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 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. 😀