A line of credit is a good option for those seeking to do home renovations or other major ongoing projects. But because the credit line's interest is calculated based on a variable rate and because you can borrow more money as time goes on, it can be challenging to calculate monthly interest payments. To do so, you have to find out the current interest rate on the line of credit, then find your average daily balance, figure out the daily interest rate, multiply the daily balance by the daily interest rate and then multiply that number by the number of days in the month.
What Are Lines of Credit?
A line of credit is similar to a loan and a credit card in that it allows you to borrow money from the bank. Whereas a loan involves the bank issuing you a pre-set amount of money that you start paying off immediately, a line of credit is more like a credit card in that you can borrow the money as it is needed, up to a pre-determined limit, and you only need to make payments while you have a balance. A line of credit also differs from a loan in that while loans usually have the interest calculated monthly, a line of credit's interest is determined daily. Lines of credit also tend to have higher interest rates than loans and some have annual fees, similar to credit cards.
The most common type of line of credit is a home equity line of credit (HELOC) in which you use your house as collateral on the money you borrow, as opposed to credit cards, which are generally unsecured. This means that if you fail to pay off your HELOC, you could lose your home. This is why HELOCs are often called "second mortgages."
HELOCs are usually set with a limit equal to your home equity, meaning the value of your home minus any other debt against the home. HELOCs typically allow you to withdraw money from the line of credit for a set period known as a draw period. At the end of the draw period, you will need to either renew your credit line, pay off the principal balance and outstanding interest immediately, or start making regular payments toward the principal or interest over a set term, just like you would with a loan or mortgage.
Line of Credit Interest Rates
To calculate the monthly interest on a HELOC, you need to determine the current line of credit interest rates. This can be a bit of a challenge because the interest on a line of credit usually is a variable rate, similar to a credit card interest rate. These rates are based on a public index like the U.S. Treasury bill rate or the prime rate, and your current rate might not be the same one you had when you signed up for your HELOC. Additionally, many lenders charge a margin percentage on top of this rate, for example, two percentage points above the prime rate.
Your most recent statement will likely say your current rate, but if you can't find it, your original paperwork will likely state how your rates are determined. You can then find the index used and add any margin charged by the lender to find your current rate. In other words, if your lender charges 2 percent, and today's rate is 9 percent, then your current rate will be 11 percent.
Calculating Interest on a LOC
Once you have your current interest rate, you can either use a HELOC payment calculator to determine the monthly interest due, or you can do it by hand. Your monthly line of credit interest will be charged based on your average daily balance and a daily interest charge for that month. Fortunately, most lines of credit use simple interest rather than compound interest, meaning you won't need to add each day's interest to your next day's daily balance.
To determine your average daily balance, you'll need to check your account. You'll need to add up your daily balances from the last month, then divide that figure by the number of days in the month. For example, say your balance was $80,000 at the beginning of the month, and then on August 8 you spent another $5,000 and you spent another $15,000 on August 20. Your daily interest for August 1-7 would be $80,000, for August 8-19, it would be $85,000 and for August 20-31, it would be $100,000. So you would multiply $80,000 by seven for the first week of the month, then $85,000 by 12 for the number of days where that was the balance and then $100,000 for the final 12 days. You would then sum up all these numbers to get $2,780,000 (($80,0007)+($85,00012)+($100,000*12)). Finally, you would divide this by 31 (the number of days in August) to get your average daily balance of $89,677.42 (rounded up).
Next, you'd need to find your daily interest rate. You could use a line of credit daily interest calculator to do this more quickly, but if you want to do it by hand, you just take your current interest rate and divide it by 365 to find the daily interest rate. For example, if your current yearly interest rate is 11 percent, your daily interest rate would be 0.0301 (0.11/365) percent (rounded down).
Finally, to find the monthly interest, you need to multiply your average daily balance by the daily interest rate and then multiply this number by the number of days in the month. Using the examples above, that would give you a daily interest payment that rounds up to $27.03, assuming you use the pre-rounded results from the previous equations (approximately 89,677.420.000301), and, using the pre-rounded sum from the previous equation, a monthly interest payment that rounds up to $837.81(approximately $27.0331).
HELOC Benefits and Drawbacks
Like almost all things in life, there are both benefits and drawbacks to obtaining a home equity line of credit. One of the biggest benefits is that this credit option is more flexible than a loan and easier to obtain. You can use the credit line as much or as little as you want up to the credit limit, and applying requires much less paperwork and fewer steps than applying for a mortgage.
Additionally, you do not need to reapply every time you need money, making this a great option if you're doing something that requires multiple withdrawals over time, such as ongoing home renovations.
On the downside, the flexibility of the loan makes it much more challenging to figure out your payments. If you only pay the minimum payments while the draw period is active, you'll only be paying off the interest and you might have a major shock when the draw period ends and you start having to pay off the principal. The end of the draw period can be even more difficult if your agreement with the bank requires you to pay off the remaining balance in full.
Additionally, your rate could increase drastically from the time you get the line of credit and these changes could make your monthly payment a surprise as well even if your draw period is still active and you haven't borrowed any additional money that month.
Finally, because home equity lines of credit are secured against your home, failing to repay the money you borrowed could result in your losing your home.