How Is the Interest Rate on a Line of Credit Determined?

A line of credit is the amount of money that a bank or other lender is willing to let a person or business have at any one time. A line of credit is generally backed by a form of a collateral, such as the equity on a property. A holder of the line of credit is not obligated to borrow the money, but can draw funds as he needs to.

Features

Unlike home equity loans, which are issued at fixed interest rates, home equity lines of credit have variable rates of interest. The interest rate that a borrower will pay on any loans drawn on the line of credit will generally be pegged to one or more indexes that track prevailing market interest rates. Typically, the borrower will pay interest equivalent to the current index rate, plus a fixed margin set by the lender.

Considerations

According to the Federal Reserve Board, lenders often offer borrowers a lower introductory interest rate on a line of credit, which typically lasts for the first six months of the line's life. If the line of credit is secured by a property, such as a home equity line of credit, federal law requires that the interest rate on the loan be capped at a certain level, even if it is a variable-rate loan. Some lines of credit also have a "floor" on interest rates, as well. Additionally, the Board states that after a loan has been drawn against the line of credit, some lenders will allow the borrower to shift the loan to one with a fixed rate of interest.

Interest Rates

Prevailing interest rates--to which most home equity lines of credit are tied--are affected by actions of a country's central bank, such as the rate at which it is willing to lend money to large financial institutions, and the investment climate as a whole.

Personal Credit History

Although the interest rate of home equity lines of credit is based on market rates, the margin added on top of the rate is based in large part on the lender's perception of the borrower's ability to pay off the loan. Borrowers with a better credit history are more likely to receive lower margins.

Expert Insight

According to the Federal Trade Commission, consumers should be aware that the rate of interest often advertised for a home equity line of credit is for the interest alone and does not include other costs, such as the margin placed on top of the loan and fees charged by the lender. In some cases, it makes better financial sense for a consumer to refinance her mortgage or take out a home equity loan rather than a line of credit.