How is Interest Calculated on a Line of Credit?

A line of credit is a type of credit account that allows you to borrow money up to a predetermined limit without needing to use the funds for a specific purpose. The main advantage of a line of credit over other types of loans is its flexibility. You can borrow as much or as little as you need, up to the maximum limit, and you only pay interest on the amount you actually use, not the whole credit limit.

If you have a line of credit or are thinking about getting one, there are a few important things to know to make sure it suits your needs.

Interest is a crucial aspect of any credit account, including a line of credit. As such, knowing how interest works on a line of credit helps you understand your financial responsibilities when borrowing and repaying the money.

How does interest work on a line of credit?

Just like a line of credit is different from a personal loan, the interest on a line of credit works differently. Instead of paying interest on the total amount, as you would with a personal loan, borrowers only pay interest on the principal balance of the line of credit that remains unpaid from the previous month’s billing cycle.

For example, if you are approved for a line of credit limit of $10,000 and borrow $6,000 during the draw period, you will only be charged interest on the $6,000 you took out.

However, if you have a line of credit but haven’t withdrawn any money from it, you’ll have no interest to pay. In other words, interest charges begin the day you withdraw money from your line of credit and continue until you repay the full amount borrowed.

Most lines of credit typically use simple interest instead of compounding interest. Some lines of credit have terms that allow the lender to demand the full amount owed, including interest, for immediate repayment if you only make the minimum payment.

How do you calculate the interest on a line of credit?

Lenders typically calculate interest by dividing the annual interest rate by 365 to get the daily rate. They then apply this rate to your daily balance. At the end of the billing period, they add up the daily interest charges.

Here’s how that looks as a mathematical formula:

(Balance × Interest rate × Number of days in the billing period) / 365 = Interest fee for the line of credit

Now, let’s break this down for you.

We’ll start with calculating the monthly interest fee for a personal line of credit. Let’s use an interest rate of 47% on a principal balance (remember, this is the amount you’ve borrowed, not the total amount of the line of credit) of $6,000. Now, we’ll say there are 30 days in this billing period. That equation will look something like this:

(6,000 x 0.47 x 30) / 365 = $231.78 interest fee

But what if you paid part of your balance during the month? Say $1,500 on the 20th? Here’s how that would look.

(6,000 x 0.47 x 20) / 365 = $154.52 interest fee

(4,500 x 0.47 x 10) / 365 = $57.94 interest fee

$154.52 + $57.94 = $212.46 total interest fee for the 30-day billing period.

But let’s say you paid off your $6,000 balance on the 14th of the month. Woohoo! Then the equation would look something like this:

(6,000 x 0.47 x 14) / 365 = $108.16 interest fee

Now, to be fair, interest calculation and charges can differ depending on the lender. But generally, the interest is based on your daily balance (a.k.a. the amount borrowed). So, as you can see from the equations above, the more you borrow and the longer you keep it, the more interest you end up paying. And the faster you pay off your balance, the less interest you’ll owe.

Also, keep in mind that the interest on a revolving line of credit can change each month depending on the balance and the interest rate. To manage your payments effectively, make sure to recalculate the interest for each billing cycle.

Paying back a line of credit

Each month, you’ll get a statement showing how much you owe and need to pay. And here’s the thing—another huge advantage of a line of credit over, say, a personal loan is that you can adjust your repayment amounts based on your budget or cash flow. You can choose to pay off your entire balance at once or just make the minimum monthly payments, which is typically just the monthly interest.

However, if you only pay the interest, you’ll never actually pay off the debt you owe. That’s why you should always pay more than the minimum amount whenever possible. Plus, by paying more into your line of credit, you’ll have more credit available should you need to borrow it again.

Line of credit interest rates in Canada

The Canadian interest rate on a line of credit changes based on the prime rate set by the lender, the Bank of Canada’s policy rate, plus a percentage. Because these rates are variable, they can go up or down over time. But once you borrow money, you’ll keep paying interest until you’ve repaid the full amount.

Your interest rate is influenced by factors like your income, personal assets, and credit score, with your Canadian credit score playing a big role in determining your rate. Generally, the better your credit score, the lower your interest rate will be because lenders see you as a safer bet. It’s similar to how credit card interest rates work, except with a line of credit, the rates aren’t fixed and can change over time.

Secured vs. unsecured lines of credit

A line of credit can be either secured or unsecured, depending on what you apply for and what the financial institution approves.

A secured line of credit generally has a lower interest rate because the collateral offers the lender security if you can’t make payments. Unsecured lines of credit usually have higher interest rates because there’s no collateral to protect the lender.

Secured line of credit

This type is backed by collateral, such as your house, car, or another valuable asset. The collateral provides security for the lender, who can take it if you fail to make payments. Secured lines of credit usually have lower interest rates because they are less risky for the lender.

Secured credit lines come in different forms, with a common type being the home equity line of credit (HELOC). HELOCs are backed by the equity in your home, allowing for a higher credit limit. While you can use HELOC funds for anything, it’s often recommended to use them for projects that provide a good return on investment, like home improvements.

Unsecured line of credit

This type isn’t backed by collateral. It can be harder to qualify for since the lender takes on more risk. Borrowers typically need a high income and credit score to be approved. Unlike secured loans, unsecured loans don’t require collateral, but you still need to pay interest and sometimes fees.

Financial institutions mainly consider your credit score and repayment history when approving unsecured lines of credit, which can lead to higher interest rates compared to secured lines.

Common examples of unsecured loans include student lines of credit and personal lines of credit.

How to get a lower interest rate on a line of credit

We know that getting a lower interest rate on your personal line of credit can really help. After all, lower interest rates mean paying less interest overall when you borrow money. And the less interest you have to pay, the more money gets to stay in your pocket for other things. Here are some ways to help you find a lower interest rate:

Improve your credit score

Many lenders will do a hard credit check to decide if you’re approved, how much you can borrow, and what your interest rate will be. A good credit score can help you get approved with a lower interest rate, while getting a line of credit with a bad credit score can be significantly more challenging.

However, if you’re looking for ways to build your credit, KOHO can help. KOHO gives you an affordable and free way to make or build your credit in Canada. You can use your own money or borrow from us to do it. There are no deposits, credit checks, or applications. And you’re guaranteed approval. With KOHO’s credit-building programs, many users see their credit scores increase by an average of 22 points just after three months by making regular, on-time payments.

Shop around

You should always shop around and compare rates from different lenders to find the best deal. Remember, you don’t have to take the first offer you get. Each lender has different requirements, so you might find a lower interest rate by looking around. Just remember that multiple hard credit checks can temporarily lower your credit score, so if you’re applying for multiple lines of credit to see which one you’ll be approved for, be sure to do it within a two-week period. This way it only counts as one hard check on your credit report.

Use collateral for your line of credit

When a secured line of credit is backed by collateral, it usually results in a lower interest rate because the loan becomes less risky for the bank. If you don’t repay, the lender can take and sell the collateral to recover their losses. So, while secured lines of credit generally have lower interest rates than unsecured ones, you need to understand the risks. If your collateral is your house (e.g., you have a home equity line of credit), and you can’t pay your line of credit back, the lender can take your house.

How to keep your interest fees low

Now, while you don’t have a lot of control over the interest rate itself (although we did mention a few things above!), you do have some control over how much you pay in interest fees. Here’s what you can do:

Only borrow what you need

A line of credit is versatile and can be used for various things, which might tempt you to take out more than you need just to have extra cash. But remember, you only have to pay interest on whatever you borrow from your line of credit and not the total limit. So, to avoid paying extra interest, make sure you only withdraw what you actually need. If you run into an unexpected expense later, you can always borrow more as long as you haven’t reached your credit limit.

Always pay more than the minimum

By paying more than just the minimum amount due, you can reduce your principal balance faster, which helps you pay off your debt quicker and saves on interest. Even small amounts above the minimum can add up over time and make a big difference.

Make your payments on time

Consistency is key when it comes to repayment. Interest is charged on your outstanding balance, so the longer you carry a balance, the more interest you’ll pay. Keeping up with your payments helps reduce your principal balance, lowering your interest charges. Plus, there’s a good chance that you’ll face additional late fees if you miss a due date.

Bad credit? Need a line of credit? KOHO can help

Start building your credit with KOHO in one of three easy ways: get a KOHO line of credit, a secured line of credit, or supercharge your credit with both. You’re guaranteed approval with no interest or applications to worry about. Plus, you can access your free credit score and financial coaching with any option.

If you prefer an alternative to a line of credit, try KOHO’s virtual credit card. It lets you manage spending easily and access funds instantly by linking the card to your phone. KOHO also offers Cover, where, for just $2 a month, you can get overdraft protection coverage that gives you up to a $250 interest-free cash advance for unexpected expenses.

No matter where you are in your financial journey—whether you want to earn interest, get cash-back rewards, or finance your next big milestone—KOHO is here to support you every step of the way.