A:

Lines of credit are flexible, direct loans between a financial institution, usually a bank, and an individual or business. Like a credit card, lines of credit have predetermined borrowing limits, and the borrower can draw down on the account at any time, provided the limit is not exceeded. Also like a credit card, lines of credit tend to have relatively high interest rates and some annual fees, but interest is not charged unless there is an outstanding balance on the account.

Interest is usually calculated monthly through the average daily balance method. This method is used to multiply the amount of each purchase made on the line of credit by the number of days remaining in the billing period. The amount is then divided by the total number of days in the billing period to find the average daily balance of each purchase. The average purchases are summed and added to any pre-existing balance, and then the average daily amount of payments on the account are subtracted. The leftover figure is the average balance, which is multiplied by the interest rate, or APR.

Interest rates are typically periodic rates that are calculated as 1/365th of the APR multiplied by the days in the billing period. There are many other ways interest is calculated and credited, but the majority of financial institutions use the methods above for lines of credit. Most lines of credit, even home equity lines of credit, use a simple interest method as opposed to compounding interest. Some lines of credit are also demand loans that are structured to allow the lender to call the loan at any time for immediate repayment, including the interest.

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