A line of credit (LOC) is a form of a flexible, direct loan between a financial

institution—usually a bank—and an individual or business. Like credit cards, lines

of credit have predetermined borrowing limits, and the borrower can draw down
on the account at any time, provided the limit is not exceeded.

Also, like credit cards, lines of credit tend to have relatively high-interest rates
and some annual fees, but interest is not charged unless there is an outstanding
balance on the account.

KEY TAKEAWAYS

 A line of credit (LOC) will give you access to loaned money if and when
you need it and may be either secured—such as a HELOC—or unsecured
—such as a credit card.
 Interest charges on LOCs usually use a simple interest method (as
opposed to compound interest).
 The average daily balance used is often arrived at using 1/365th multiplied
by the days in the billing period.
Lines of Credit
Lines of credit have the same features as revolving credit such as a credit card.
A credit limit is established, and funds can be used for a variety of purposes.
Interest is charged at regular intervals, and payments may be made at any time.1

There is one major exception: The pool of available credit does not replenish
after payments are made. Once you pay off the line of credit in full, the account is
closed and cannot be used again.

As an example: Personal lines of credit are sometimes offered by banks in the

form of an overdraft protection plan. A banking customer can sign up to have an
overdraft plan linked to his or her checking account. If the customer goes over
the amount available in checking, the overdraft keeps them from bouncing a
check or having a purchase denied. Like any line of credit, an overdraft must be
paid back, with interest.2

Most lines of credit are unsecured loans. This means the borrower doesn't
promise the lender any collateral to back the LOC. One notable exception is a
home equity line of credit (HELOC), which is secured by the equity in the
borrower's home. From the lender's perspective, secured lines of credit are
attractive because they provide a way to recoup the advanced funds in the event
of non-payment. Unsecured lines of credit tend to come with higher interest rates
than secured LOCs. They are also more difficult to obtain and often require a
higher credit score. Lenders attempt to compensate for the increased risk by
limiting the number of funds that can be borrowed and by charging higher interest
rates. That's one reason why the APR on credit cards is so high. Credit cards are
technically unsecured lines of credit, with the credit limit—how much you can
charge on the card—representing its parameters.

Interest Calculation for Lines of Credit

Most lines of credit, even home-equity lines of credit, use a simple
interest method as opposed to compounding interest. Some lines of credit also
demand loans that are structured to allow the lender to call the total amount due
(including the interest) at any time for immediate repayment.

Interest on a line of credit is usually calculated monthly through the average daily

balance method. This method is used to multiply the amount of each purchase
made on the line of credit by the number of days remaining in the billing period.
The amount is then divided by the total number of days in the billing period to find
the average daily balance of each purchase. The average purchases are
summed and added to any pre-existing balance, and then the average daily
amount of payments on the account is subtracted. The leftover figure is the
average balance, which is multiplied by the annual interest percentage rate
(APR).

Interest rates are typically periodic rates that are calculated as 1/365th of the
APR multiplied by the days in the billing period. There are many other ways
interest is calculated and credited, but the majority of financial institutions use the
methods above for lines of credit.3

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