Line of Credit Calculations

A line of credit allows a person to borrow up to a specific amount of money and repay it over time. As the borrower repays money, he frees up part of the credit line to borrow more. Use a few different types of calculations when planning how to use a line of credit.

Credit Limit

Lenders use a few strategies to calculate the credit limit for each borrower. The borrower's creditworthiness, income and amount of collateral, if applicable, all contribute. The higher a borrower's credit score, the more he can be held responsible to repay. Borrowers with higher incomes generally get larger lines of credit because they have more money available for monthly payments. Lastly, for home equity lines of credit, the borrower generally needs to have available equity in his home to secure the full line of credit. Calculate the potential credit line by multiplying the home's current value by 0.8 and subtracting the amount of the existing mortgages secured by the home.

Interest Calculations

The amount of interest due on a line of credit depends on the balance owed and the interest rate. Credit card companies generally average the balance owed on each day during the billing period to find the average daily balance. Home equity lines of credit might just use the ending balance. Divide the annual interest rate by 1,200 to calculate the monthly interest multiplier. For example, divide a 7.2 percent interest rate by 1,200 to get a monthly multiplier of 0.006. If the borrower's balance was $21,000, the interest that month would be $126. If the line of credit has a variable interest rate, the borrower needs to use the current interest rate for the calculations.

Payoff Plan

When you are done drawing on a line of credit and want to pay it off, calculating a plan can help motivate you to stay on track with monthly payments. To calculate a plan by hand, calculate the interest for the first month and subtract your payment above the interest from the principal balance. Repeat the process for each subsequent month to find out how long it will take to pay it off at that interest rate. Another option is to use an online calculator to determine either your payoff time with a particular monthly payment or the monthly payment you need to make to be debt free by a particular date. When calculating a payoff plan, remember that it will not be completely accurate if your interest rate changes.

Risk

Borrowing with a home equity line of credit can be risky because the lender places a lien on the home. If the borrower fails to make payments as agreed, the lender has the right to initiate foreclosure. Because a home equity line of credit generally has a variable interest rate and begins with interest-only monthly payments, the amount of the monthly payment can increase dramatically over the repayment term. Homeowners should consider what they can actually afford to repay each month before taking out a line of credit.