Revolving credit can be a convenient and flexible option when it comes to borrowing money. But what exactly is revolving credit? Find out how it works and if revolving credit is best suited to your financial plans.
Definition of revolving credit
Revolving credit is a line of credit that you can borrow and repay over and over again.
“Revolving credit can be considered easy access to borrowing,” says Michael Sury, finance department faculty member and managing director of the Center for Analytics & Transformative Technology at the University of Texas at Austin. In other words, it allows you to borrow up to a pre-determined amount as needed and then pay off the balance when you have the funds available. “Repaying the loan frees up funds to borrow again – hence the term ‘revolving,'” Sury adds.
How does revolving credit work?
Revolving credit means you borrow against a line of credit. Suppose a lender gives you a certain amount of credit, on which you can borrow repeatedly. The amount of credit you are allowed to use each month is your credit line or credit limit. You are free to use as much or as little of this line of credit as you wish on any purchase.
At the end of each statement period, you receive an invoice for the balance. If you don’t repay it in full, you carry the balance over to the next month and pay interest on that amount. As you pay off the balance, more of your line of credit becomes available.
What are the types of revolving credit?
There are two main types of revolving credit: secured and unsecured.
Secured revolving credit means that the line of credit is backed by a guarantee. This could be an asset like real estate or a cash deposit. If you do not repay the balance according to the terms of your contract, the creditor can seize this property.
Unsecured revolving credit means that there is no collateral securing the line of credit. This type is much riskier for the creditor and often comes with higher interest rates.
What are the examples of revolving credit?
“A classic example of revolving credit is a credit card,” says G. Brian Davis, personal finance columnist and co-founder of Spark Rental, an educational site for real estate investors. “The balance goes up and down as the consumer pays or bills it. The monthly payment fluctuates as the balance changes.” Credit cards are a type of unsecured revolving credit.
An example of secured revolving credit is a home equity line of credit. A HELOC works the same way as a credit card, except the line of credit is secured by the equity in your home.
Revolving Credit Vs. Ladder Loan
Revolving credit is different from a traditional loan, which is repaid at regular intervals. These installment loans are meant to help you borrow money for a specific purpose – to buy a car or to cover school fees, for example. Essentially, you borrow a large sum of money and repay it in monthly installments until the debt is exhausted.
Consider the difference between a HELOC and a home equity loan. “A HELOC is a revolving line of credit that homeowners can draw on or pay off,” Davis explains. But a lump sum home equity loan has a fixed loan amount and repayment term. “It’s a classic installment loan,” he says.
Revolving credit is best when you want the flexibility to spend credit month after month, without a specific goal set in advance. It can be beneficial to spend on credit cards to earn rewards points and cash back – as long as you pay off the balance on time each month.
How do revolving accounts affect your credit?
Every time you spend on credit, it can impact your FICO credit score, the score most commonly used by lenders. How you manage this credit will determine whether the impact is positive or negative.
Missing payments on credit cards or other revolving credit accounts can have a dramatic and lasting impact on your score. But if you consistently make your payments by the due date, you’ll build a positive payment history that will boost your score over time.
The amounts you owe represent 30% of your score. Relying too much on the credit extended to you is a major red flag for lenders, as it may seem like you don’t have enough money to meet expenses. The last thing you want to do is max out your credit lines.
To find your credit utilization rate, a measure of how much credit you are using, divide your total outstanding balances by the total amount of credit you have been granted.
For example, if you have a total credit limit of $3,000 and you have a balance of $1,000, your credit utilization rate would be approximately 33%. The lower your usage, the better for your score. Aiming for less than 10% is ideal.
Keep in mind that your credit usage may be high even if you pay off your balance every month. This is because your balance is often reported to the credit bureaus on the day your statement closes, which is different from the due date when you might pay it off. For this reason, it’s best to avoid building up a large balance, even if you plan to pay it off within a few weeks.
Credit history and new credit
Creditors like to see a long and steady history of responsible credit use, which is why your credit history makes up 15% of your FICO score. The older your credit accounts, including credit cards and other types of revolving credit, the better.
At the same time, too many accounts opened in a short period of time will not only lower your average credit age, but also signal to lenders that you may be in desperate need of more credit. This is why new credit represents 10% of your FICO score.
If you apply for revolving credit and are denied, consider the factors that led to the denial and work to improve them before reapplying. Or look for a product with a better chance of approval.
Composition of credit
The bottom 10% of your credit score is based on your credit mix. Lenders like to see that you have experience handling different types of debt, including a good mix of installment loans and revolving credit.
So if you have limited credit experience — maybe you only have student loans in your early adult life — it might be beneficial to diversify with a revolving credit account, like a credit card. .
Advantages and disadvantages of revolving credit
Although revolving credit can be useful in some cases, its use also has disadvantages. Zoom on the advantages and disadvantages of revolving credit:
- It is convenient. The ability to borrow money when you need it, for just about any expense, is much more flexible than taking out an installment loan for a lump sum and then paying it back on a fixed schedule.
- It’s effective. As long as you make your payments on time, a revolving line of credit such as a credit card can improve your credit score. “Establishing good credit and a good payment record is a great way to maintain or improve your credit score,” Sury says.
- It’s expensive. Revolving lines of credit usually come with higher interest rates than installment loans. This is especially true if the line of credit is unsecured.
- It’s limited. Typically, the credit limit of a line of credit is lower than that of an installment loan. So if you need to borrow a large sum of money, a revolving line of credit may not be enough.
How to manage revolving credit
Revolving credit can help you manage your expenses before your next paycheck arrives. Plus, using rewards credit cards on purchases you need to make anyway is a great way to put money back in your pocket. Just make sure you’re doing it right.
- Keep the balances low. With a credit card or other types of credit, you can use up to 100% of the credit granted to you. But that doesn’t mean you should. Maximizing your line of credit will lower your credit score. If you can’t pay off your balance, another option is to increase your credit limit. However, the key is not to add more debt to your new higher limit.
- Pay on time each month. Most issuers will charge a late payment fee, and some will increase your annual percentage rate on future purchases as a penalty. A penalty rate may apply for late payments of 60 days or more, and late payment could result in a potentially significant drop in your credit score. Staying on top of your bills is the most effective thing you can do to maintain good credit.
- Avoid too many requests for revolving credit. Before applying for a credit card or other type of credit, make sure your credit score is in good shape to avoid being rejected. And if you’re approved, space out future applications to avoid hurting your credit score.
Revolving credit can have a positive or negative effect on your credit score, depending on how you use it. If you’re a responsible spender and pay your bills on time, you should be able to use credit to your advantage while building a good credit score.