How Line of Credit Interest Is Calculated, Day by Day

A client rang me last spring holding her first line of credit statement and a calculator. She had drawn $20,000 at a 10 percent rate, expected the month's interest to be a twelfth of $2,000, about $166, and the statement said something slightly different. The month before, when she had paid half of it back mid-month, the figure had been much lower than she guessed. Neither number was wrong. She just had not been told how the bank actually counts.

Line of credit interest is not calculated the way most people picture it. It runs day by day on whatever balance you owe that day, and the convention the lender uses for the length of a year quietly nudges the cost. Once you see the mechanics, you can time draws and repayments to pay noticeably less for the same borrowing.

Interest follows the daily balance, not the limit

On a typical bank line, you pay interest only on the amount drawn, never on the approved limit. A $50,000 line with nothing drawn costs nothing in interest, though it may carry fees, which we will get to.

The lender converts the annual rate into a daily rate and applies it to each day's closing balance. At the end of the billing cycle those daily charges are added up. Many statements show this as an "average daily balance" multiplied by the daily rate and the number of days in the cycle, which comes to the same thing.

This is the part that matters for an owner: because the meter runs daily, the date money goes out and the date it comes back change the bill. A repayment on the 5th saves more interest than the same repayment on the 25th.

The 360-day year that most owners never notice

Commercial lenders in the US frequently calculate interest on an "actual/360" basis. They divide the annual rate by 360 to get the daily rate, then charge it for the actual number of days that pass, 365 in a normal year. The effect is that a stated 10 percent rate costs a little more than 10 percent over a full year: 10 multiplied by 365/360 is roughly 10.14 percent.

That gap is small on a single month and not a scandal; it is a long-standing banking convention and it is written in the agreement, usually in the interest section under a phrase like "computed on the basis of a 360-day year and actual days elapsed." But if you are comparing two lines and one uses actual/365, the two headline rates are not quite like for like. I ask every client to find that sentence before signing.

A worked example, step by step

These are illustrative numbers, not a quote from any lender: a $20,000 draw on a line at a 10 percent annual rate, over a 30-day billing cycle. The only thing that changes between rows is the timing and the day-count convention.

The arithmetic for the first row is $20,000 × 0.10 × 30 ÷ 365. For the third row, the balance was $20,000 for fifteen days and $10,000 for fifteen days, so the average is $15,000 and the same formula gives $123.29. Paying half back halfway through the month cut the interest by about a quarter, which is exactly what surprised my client.

The fourth row is the one I bring up most with clients who draw "just in case." Drawing two weeks before the money is actually needed doubles the interest for that month, and you are paying to hold cash in a current account.

"Just pay the minimum and clear it later" costs more than it looks

During the draw period, many lines only require interest each month. The common advice from owners who have done it is that this keeps things cheap, and in a narrow sense it does: the monthly payment is small. What it hides is that the balance never falls, so every single day of every month is charged at the full drawn amount.

A simple habit changes that. When a customer invoice is paid, send part of it to the line the same day rather than waiting for the statement. Every day earlier is a day of interest not charged. I build these repayments into the client's weekly cash forecast, the same sheet I describe in forecasting cash flow without a finance degree, so the line gets paid down as cash arrives instead of in one lump.

The exception: lines that charge a fee per draw

Some online lenders do not use a daily rate at all. They charge a fixed fee on each draw, payable over a set number of weekly or monthly instalments, for example over six or twelve months. On that structure, repaying early may save you little or nothing, because the fee was fixed when you drew. Read the agreement for the words "fee," "factor" or "prepayment" before assuming that the daily-interest habits above apply. If the cost is set at the moment of the draw, the only lever left is drawing less.

Fees that sit beside the interest

Interest is the biggest cost on most lines but rarely the only one. The three I check on every agreement:

• Unused line fee. A small annual percentage charged on the part of the limit you have not drawn. It rewards the bank for keeping the money available, and on a large, rarely used line it can exceed the interest.
• Annual or maintenance fee. A flat charge for keeping the line open, often taken at renewal.
• Draw or transfer fees. Charged per draw on some products, which punishes many small draws.

If the line is mostly idle, the fees may make it more expensive than you think; in that case it is worth rereading when a line of credit beats a term loan, because the answer depends on how often you will really draw.

One thing to do this week

Pull your line of credit agreement and your last statement. In the agreement, find the day-count sentence (360 or 365) and every fee. On the statement, check the average daily balance and multiply it by your rate, the days in the cycle and the right divisor; the result should match the interest charged within a few cents. If it does not, ring the bank and ask them to walk you through it. Then set one rule for the coming month: any customer payment over a set amount goes partly to the line the day it lands. More on how these products work sits in the lines of credit section.