How a Line of Credit Interest Works
A line of credit provides open and ongoing access to money that you can borrow for any purpose you choose. Common lines of credit include credit cards and home equity lines of credit, which are a type of second mortgage. In either case, you'll pay interest on the money you choose to borrow, which can make a line of credit a costly way to make purchases.
Other People Are Reading
-
Interest Rates
-
Most lines of credit use variable interest rates. This means that the introductory rate, which may be very low, is subject to change over time. Under the federal Truth in Lending Act, lenders must disclose the terms of the line of credit when you sign up, including how often they can raise your rate and under what circumstances. Some lines of credit have maximum interest rates that cap how much you will need to pay, while others do not.
Finance Charges
-
Lines of credit typically feature an annual percentage rate, or APR, but charge interest on a monthly basis. This means that each month your lender multiplies the amount you owe --- your line of credit's balance --- by one-twelfth of the APR. For example, if you charge $500 to your credit card, which has a 14 percent APR, your first month's finance charge will be $5.83. Each month, you'll need to make a minimum payment that includes the previous month's finance charge, as well as a portion of your line of credit balance. Your lender will require you to pay a minimum dollar amount or a percentage of your account balance, whichever is higher, plus the finance charge.
-
Revolving Credit
-
Some lines of credit, such as credit cards, feature revolving credit. This means that even though your line of credit has a maximum credit limit --- the most you can borrow at any time --- you can borrow continuously as you make payments. Each time you make a monthly payment, it reduces your account balance and allows you to borrow more, back up to the original credit limit. Interest charges apply to your account balance regardless of whether you've approached or even exceeded your credit limit.
Pros and Cons
-
A revolving line of credit means you can continue to incur finance charges indefinitely until you pay off your entire balance and stop making new charges. If you can pay off a line of credit before the interest rate rises, it probably represents a lower-cost option than a fixed-rate loan. However, if you fail to pay off the line of credit before rates change, you'll likely pay more to borrow the same amount of money.
-
