There are two common types of line of credit accounts available to most consumers. Credit card accounts allow you to make purchases up to the line of credit (usually called the card's credit limit). A home equity line of credit (HELOC) works in a similar fashion, but the money you borrow is secured by putting your house up as collateral. Interest is calculated by most line of credit providers using the average daily balance method.
A line of credit is an account that allows you to borrow money as you make purchases up to a specified limit. Interest is calculated monthly on the outstanding balance (the total you owe) of the line of credit at a rate proportional to the annual percentage rate of interest (APR). The average daily balance method, which is the method most often used, requires that you first figure the average balance outstanding and the periodic interest before calculating interest on a line of credit.
To compute the average balance, first multiply the amount of each purchase by the number of days in the billing period remaining at the time the purchase posted to the account, and then divide by the total number of days in the billing period to find the average daily balance of the new purchase. For example, if you made a $100 purchase that posted with 18 days remaining in a 30-day billing period, you have ($100 x 18)/30 =$60. Add up the average daily balances of all new purchases. Follow the same procedure for each payment you make on the line of credit to find the average daily amount of payments made. Add the average daily balance of all new purchases to the previous balance on the line of credit (from the most recent statement). Subtract the average daily amount of payments made. This is your average balance for the monthly billing period.
Figure the interest rate for the billing period by dividing the APR by 365 (the number of days in a year). Then multiply by the number of days in the billing period. For example, if the line of credit interest rate is 10.95 percent and there are 30 days in the billing period, you have (10.95 percent/365) x 30, which equals a periodic rate of 0.90 percent.
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The calculation of interest on a line of credit is very simple once you have the average balance and period rate. Simply multiply the two to find the amount of interest for the monthly billing period. For example, if the average balance is $7,500 and the periodic interest rate is 0.90 percent, you multiply the two numbers to get an interest charge of $67.50.
Some line of credit providers use variations on the average daily balance method. For example, you will occasionally see credit card accounts where the interest is figured using a monthly periodic rate (1/12 of the APR) and simply ignore the variations of a day or two in the length of the billing period. Another approach is to use the adjusted balance method. The balance used for the interest rate calculation is the ending balance from the previous month, minus all payments. New purchases are added to the balance after interest is calculated.