How Does Interest Work on a Revolving Loan?
A revolving loan doesn't follow a normal amortization schedule and, as a result, requires careful monitoring to determine your monthly interest. To properly calculate interest, you need the proper information from your documents as well as the amount and dates of your payments and advances. With this information, you can verify that you're paying the proper amount.
A revolving credit loan does not have a pre-determined end like certain other types of loans. Instead, your unpaid balance continues to "revolve" (carry over) from month to month.
How Revolving Loans Work
A revolving loan is a credit line that you can access and pay back as needed, and the interest is based on the amount you use. A lender grants you a loan up to a limit, $100,000 for example. If you need $10,000, you will write a check or request a transfer into your checking account, leaving you $90,000 available. If you pay back half of the amount borrowed, your credit limit will be increased to $95,000.
Understanding Interest Accrual
Interest accrues every day based on the interest rate and the outstanding principal balance of the loan. Say, for example, you borrow $10,000 on January 1st, pay back $5,000 on the 5th and another $5,000 on the 10th. Interest will accrue on $10,000 from the 1st to the 5th and $5,000 from the 6th to the 10th. Once the balance is paid to $0, interest stops accruing.
Exploring Loan Interest Rates
The amount of interest that accrues is based on the interest rate. Revolving loans are based on an index, typically the Wall Street Journal Prime Rate that floats daily. Floating means that every time the rate changes, your rate changes with it. So if your rate is prime plus 1 percent and prime is priced at 3.25 percent, your overall rate will be 4.25 percent. If prime goes up to 3.5 percent, your rate will go up to 4.5 percent and so on.
Calculating Loan Interest
Interest on a revolving loan is calculated on an actual day over 360 basis. This means it is calculated based on the actual days the money is borrowed over a year consisting of 360 days.
For example, you have $10,000 borrowed at 4.25 percent for five days. Multiply 10,000 by 0.0425, which will give you 425. Multiply that figure by five to get 2,125. Divide that figure to by 360 to see that your interest payment for those five days is $5.90.
Minimizing Interest Charges
The higher your credit score is, the better interest rate you may be able to get for your revolving credit line. And a good repayment history for your revolving credit line will help boost your credit score.
Credit rating agencies such as Experian recommend keeping the balance on your credit line below 30 percent. For example, if you have a credit limit of $10,000, it's best to keep a running balance of no more than $3,000. And even better, if you can pay your outstanding balance in full before the due date each month, your credit rating will also benefit.
Carl Carabelli has been writing in various capacities for more than 15 years. He has utilized his creative writing skills to enhance his other ventures such as financial analysis, copywriting and contributing various articles and opinion pieces. Carabelli earned a bachelor's degree in communications from Seton Hall and has worked in banking, notably commercial lending, since 2001.