Line of Credit
How a Canadian Line of Credit Charges Interest
In words you can understand!
The “Line of Credit” is a popular choice of borrowing vehicle amongst Canadians and other consumers around the world. In Canada, there are good reasons for this popularity.
- Interest rates are often times much lower than credit cards or term loans.
- Lines of credit are very flexible. We can use them to purchase anything we choose including a home or car.
- In most cases, a Canadian line of credit will not charge an annual fee.
Most experts would agree that the line of credit is the most favourable type of liability a Canadian consumer can carry. The reasons for this have to do mainly with the way a line of credit actually charges interest.
First and foremost, lines of credit are set up for us to “play” before we “pay” by charging interest at the end of the month. In addition, when calculating the interest for the previous month, the line of credit charges interest on the average daily balance for that month.
For example, let’s assume we are approved for a line of credit at 5% interest annually with a credit limit of $20,000. The first day we get it we are so excited, we decide to purchase the $5,000.00 big screen T.V we’ve had our eye on for months! From the 1st of the month until the 10th we carry a $5,000.00 balance. On the 11th of the month we spend another $5,000.00 on a new bedroom set and our balance jumps to $10,000.00. Now we’re so comfortable we sleep until the 20th of the month, wake up and find a way to spend yet another $5,000.00 bringing our balance to a whopping $15,000.00! Realising we need to be stopped, we lock ourselves inside until the end of the month and do not spend another penny.
On the last day of the month, the bank’s interest calculator takes a look at our line of credit account activity to determine the average daily balance from our binge spending month. We had 10 days with a $5,000.00 balance, 10 days with a $10,000.00 balance, and 10 days with a $15,000.00 balance, right? Our average daily balance then, is $10,000.00. Now the bank charges us 1/12 of 5% interest for that one month (0.42%) and charges that amount ($42.00) to our line of credit which slightly increases our principle owing on the line ($10,042.00) to begin the next month.
The interesting strategic note we all need to understand about the way a line of credit charges interest is this…if you have to carry a balance on your line of credit, then make sure to keep the balance as low as possible for as many days as possible every month. Try using your income to temporarily reduce the balance on your line of credit just by sitting there instead of in a chequing or savings account earning a useless amount of interest if any at all. Ideally, you would want to put your income in to the line early in the month and withdraw anything you must near the end of the month…make sense?
BANKING TIP - Learn to deposit your income into the line of credit every time you get paid, then use your credit card to pay as many of your monthly expenses as possible throughout the month, then use your line of credit to pay the credit card at the end of the month. This would allow you to keep your line of credit balance low for as many days of the month as possible. It would also make use of your credit card’s privilege of spending on it without paying interest for 30-45 days. (Review How a Credit Card Charges Interest for more information) Banking this way, you pay minimal interest on your line of credit and no interest on your credit card.
That’s just one way you can learn how to Bank Like the Bank and save loads of money long term…if you choose.
