Home » Resources » Blog » Revolving Credit Simplified: The Basics, Benefits, and Examples
- Blog
Revolving credit is popular with many consumers because of its flexibility. Commonly available through credit cards, revolving credit can be used to finance a broad range of purchases, and provides payment flexibility: it allows you to pay the full balance, a minimum balance due on the account, or an amount in between each month. Additionally, open revolving lines of credit benefit your credit profile even when you’re not holding a balance on it.
The benefits are undeniable, but it also comes with some downsides. We’ll get into what revolving credit is, the benefits of using it, and some common examples of it.
What Is Revolving Credit?
Revolving credit is a form of short-term credit where the borrower can continue using their credit limit as needed over time. It can usually be used for just about any purpose, though some revolving lines of credit may have restrictions.
As long as the monthly payments are made on time and the account is kept in good standing, it can be used as many times as needed without applying for another account. For this reason, it’s also referred to as an evergreen loan or open-end credit.
Flexibility is key with a revolving credit account. Borrowers get to choose:
- How much of their credit limit to use
- Whether they want to pay off the balance over time or right away
- What to spend the money on
Compared to installment loans, these features provide consumers with credit they can use in their own way, depending on their particular circ*mstances. In addition to the flexibility of using revolving credit, there are also plenty of reasons why people use them as opposed to other forms of payment.
- Financial cushion in emergencies
- Help manage cash flow
- Provides a level of protection against theft
- Earning rewards for everyday purchases
A popular use of revolving credit is often to cover unexpected expenses, or emergencies where the cash needed to solve a problem isn’t available. It could be car trouble, home repairs, medical issues, or otherwise. Many people also use credit cards (the most popular form of revolving credit) to protect against theft, since most cards will provide protection against unauthorized purchases.
Credit card borrowers generally aren’t liable for fraudulent purchases. This comes in handy if your card information is stolen. The thief won’t have access to the cash in your bank account through a debit card. They only have access to your credit line, and you’re protected against unauthorized use if they start making charges.
Many credit cards carry an added benefit of rewards – cash back, travel points, discounts at specific stores, and special offers for users of some cards can make it very beneficial to use revolving credit for regular purchases, as long as you manage your balance responsibly.
Lines of credit are also useful for managing cash flow by covering the payment of expenses until cash is available – filling up a tank of gas on Friday before you get paid on Monday, for example.
How Does Revolving Credit Work?
Now that we know what it is, here’s how it works. The lender issues a credit limit on the approved credit card or line of credit. They determine what the credit limit is using several factors including
- Debt to income ratio
- Credit score
- Total income
- Credit report details
- Market conditions
In the case of a home equity line of credit or secured credit card, the bank may also require the rights to collateral such as a house or funds to secure the credit account and reduce the risk associated with it.
Revolving credit payments are typically due monthly. Unlike non-revolving, or installment, credit, there’s an option to pay the minimum payment, the full balance, or an amount that falls in between the two.
Your minimum payment is determined by any outstanding balance carried over at the end of a billing cycle. It’s also affected by the annual percentage rate (APR) that’s on the credit line.
A minimum payment is usually a fixed dollar amount or a percentage of the total balance, whichever amount is higher, assuming there is a balance at all. Be sure to understand how your minimum payment is calculated, even if you’re planning on paying more than the minimum or not carrying a balance at all.
As the revolving account is used, a running balance is totaled. If the outstanding balance is paid off in full before the end of the billing cycle, no interest is applied. If a balance is carried over, then the monthly payment consists of the principal balance plus any fees and interest charges.
The available credit limit is restored as payments to the revolving account balance are made. Any balance carried over is affected by compounding interest. As an example, if you have an outstanding balance of $300 and an interest charge of $20, and paid nothing that month. you’d be charged interest on $320 the next time intereset is calculated. This can make credit card debt and other revolving debt more difficult to pay off if you let balances spiral out of control.
What Are Examples Of Using Revolving Credit?
Let’s start with a simple example.
Imagine a scenario where your car breaks down and a mechanic quotes $2,000 to fix the issue. Your checking account balance is currently $700, but you need your car to commute to work, pick up the kids, and run your errands.
You’re in a pinch because without credit, you can’t afford the extra $1,300 it takes to fix the car. You also can’t afford the alternative of losing your sources of income (or else how are you ever going to make the extra $1,300 to fix the car?).
Using revolving credit like a credit card or personal line of credit allows you to access the funds to pay for the auto repair, and gives you the flexibility to pay the $2,000 over time, instead of all at once, so you can use a portion of your next several paychecks to pay the balance instead of the entirety of the next check you receive.
In this scenario, you’d be using a credit card or a personal line of credit, which are two common examples of revolving credit.
However, what if instead you are trying to complete renovations to your home? If you’ve been through renovations, you know that sometimes costs run over budget. Without extra funds to pay for an unexpected overage, you could be sitting in construction dust for much longer than anticipated.
Applying for a home equity line of credit or HELOC can cover the additional construction costs without delaying the renovation. Simply transfer the additional funds to a bank account or write a check from the HELOC to pay the contractors. In this instance, a home equity line of credit is a revolving line of credit that you can use to pay for items now, secured by the value of your home. How large your line is will be influenced by how much equity you have in your house (the value of your home less the balance you owe on any mortgages).
What Are 3 Types Of Revolving Credit?
Revolving credit can be divided into either secured or unsecured credit. Secured credit means that collateral is required to qualify for an account, while unsecured means that the creditor is using your credit profile to determine that you don’t need to put up any collateral before issuing you the line.
It’s important to know both what type of revolving credit is best suited to your purposes, and whether it’s secured or unsecured.
Credit Cards
This is the most popular type of revolving credit. Credit cards don’t typically require any form of collateral unless you get a secured credit card. Unsecured credit cards are considered a high-risk product for banks and financial institutions, since they sometimes allow people to spend beyond their means and fall into a never-ending debt cycle.
As such, they usually assign higher interest rates for credit cards that can fluctuate with the market rates. Average credit card interest rates hover around 15%-18% for well-qualified borrowers. However, they can reach much higher for borrowers with credit issues.
Credit cards have the potential to earn rewards on purchases made. These rewards can be anything from cash back, points, or travel mileage. If you’re using a credit card, your credit score will be best impacted by keeping your balances low relative to your total approved line (ideally between 2-9% of your approved line) and making sure to make on-time payments of at least the minimum balance – ideally more.
Personal Line of Credit
A personal line of credit is an unsecured credit line that’s similar to a credit card but with a few key differences. First of all, there’s usually no card associated with a personal line. That might seem like a restriction, but it really isn’t.
Instead of a card, you can transfer funds from the personal line of credit directly to your bank account so it acts like cash. To do the same thing with a credit card would create a cash advance which comes at a much higher interest rate than other transactions.
Personal lines of credit typically have lower interest rates than credit cards. On average a personal line is usually around 10%-12% for people with good credit.
Home Equity Line of Credit
A home equity line of credit uses the equity in a residential property to extend credit to the homeowner. Since it uses a house as collateral for the line of credit, these often come with much lower interest rates than a typical credit card.
HELOC interest rates are usually under 5% for borrowers with good credit.
Is Revolving Credit A Good Idea?
As long as you manage the account well, revolving credit can provide a boost your credit score. The most important number to pay attention to with any revolving credit is your utilization rate, calculated by dividing your total balance by the size of your line. Utilization makes up 30% of your overall credit score.
It’s best to keep your credit utilization ratio under 30% of your credit limit to avoid any negative impacts on your credit score, and ideally lower – most experts recommend keeping your utilization between 2-9%. If you let your credit utilization get out of hand it could contribute to difficulties paying off your revolving debt.
What Is The Difference Between A Credit Card And Revolving Credit?
Revolving credit and credit cards might sound like two completely different financial products, but they’re actually the same thing! A credit card is a type of revolving credit account.
It’s just that a credit card describes a specific financial product while revolving credit is the larger category that a credit card falls into.
How Does Revolving Credit Impact Your Credit Score?
The impact that revolving credit has on your credit score depends on how you use it. Having both revolving and installment credit impacts your credit mix positively, which can help your score.
For someone who pays their monthly payments on time every time, and keeps their credit utilization low, a revolving credit account could create a substantial increase in your credit score, especially if the account is kept in good standing for multiple years and contributes to the age of your accounts.
A borrower who maxes out their credit cards or has trouble keeping up with their payments will most likely see a decrease in their score.
For the best effects on your credit, you should use your revolving credit responsibly. Don’t spend more than you can afford, keep your utilization rate low and make your monthly payments on time. A late payment can remain on your credit profile for 7 years, so consider setting up auto-payments for the minimum amount to ensure you never miss one.
Revolving credit is only as good as the borrower using it. These types of credit accounts are extremely useful when used properly. They can cover you in emergencies, improve household cash flow and even protect your cash accounts from fraud.
It can be easy to let your revolving credit get out of hand since the interest rates can be high and the interest is compounding. However, with conservative use of your revolving credit accounts, you can see big changes in your credit profile.
Share article
