Cash 1 Blog
What Is Revolving Credit & How Does It Work?
It can be easy to get overwhelmed by the different types of credit options.
When researching, you come across many different terms. One that you'll come across is the term revolving credit. This may lead you to ask, What is revolving credit? What types of borrowing fall under this category? And what advantages and disadvantages does this type of debt offer the average consumer? Knowing this information will help you borrow responsibly, preserve your credit score, and could even save you thousands of dollars down the road.
In this article, we'll break it down so you can make more informed financial decisions.
Revolving Credit Examples
At its root, revolving credit means that borrowers are given money that is repaid and then borrowed again. As opposed to a one-time loan, you're able to borrow against your credit line after you've paid back what you owe.
This type of borrowing is ongoing or revolving, meaning you can continue to borrow against your line of credit as you see fit. In some cases, you may even get approved for a larger credit amount. There are different types of credit lines. Below are common examples of revolving credit to help you understand each kind you might get or apply for.
Given the definition, you might have put it together already that credit cards are an example of revolving credit.
Credit cards are typically issued with a credit maximum (i.e., $5,000) and a fixed interest rate. This means borrowers can put no more than the maximum on their account and must pay back what they owe at that rate. If you have poor credit or don't have a credit history at all, interest rates can be between 20 and 30 percent. The average is usually between 15 and 17 percent.
A home equity line of credit (HELOC) is a type of revolving credit where the borrower puts their home down as collateral.
The amount borrowed comes from the equity in your home, which is the difference between how much you owe on your mortgage and how much of it you've paid back.
If the loan is not repaid in the predetermined amount of time, the lender reserves the right to sell your home or establish new terms that may force you to take out more debt on your home.
Store Credit Cards
Many outlet and retail stores offer their in-house credit options for shoppers.
Stores like Kohl's, Walmart, and other retailers typically offer customers incentives in exchange for signing up. Sometimes, seeing if you're approved for a store credit card (without signing up) can save you.
Like a credit card, this amount must be paid off each month, or it accrues interest charges. Each store's terms are different, so understanding what you're signing up for is key.
Bank Accounts With Overdraft Protection
Have you ever swiped your debit card for a purchase that cost more than how much was in your account?
If so, there's a chance that overdraft protection kicked in. This feature is available at many banks and covers the difference between how much is left in your account and how much you need to cover the charge made.
While this is technically a line of credit extended to you, it can happen in your checking or savings account or using a debit card. Check with your bank to understand their requirements for using overdraft protection. Sometimes, you don't even have to pay a fee if you promptly reimburse the bank.
Gas Station Cards
Like store credit cards, some gas stations offer revolving lines of credit. They can only be used at one specific chain (usually) and be put towards fuel or in-store purchases.
These benefit people who drive a lot for work or need to fill up. As a customer, you typically are given cashback rewards or save on fill-up by swiping the card.
Personal Lines Of Credit
A personal line of credit is more like a credit card than a personal loan.
With a personal loan, you borrow a set amount and pay it back. Once finished, the agreement is over. On a personal line of credit, you can continue to make revolving charges to your account and pay interest only on what you owe.
Business Lines Of Credit
A business line of credit is the same as outlined above—just for your company's needs.
Some entrepreneurs and business owners take out a line of credit when expanding or pivoting their business. The line of credit gives them the flexibility to make purchases and pay it back as they go.
Margin Investment Accounts
There are even common types of revolving credit in the brokerage world. The most popular is known as a margin investment account.
Here, borrowers pay a portion of a stock price, and the broker lends them the difference. As the borrower, you then pay interest on the loan. If the stock makes money or you earn interest, this helps offset the cost.
Difference Between Revolving Credit and Installment Loans
Both can be popular (and helpful) options in the face of a financial crisis. But knowing the difference between installment loans and revolving credit is important.
In short, revolving credit is a more flexible type of borrowing. As outlined earlier, the borrower pays interest only on what they borrow. As it's paid back over time, the borrower can choose to take more if they want. They may even be able to secure more funding if they are responsible for borrowing.
An installment loan is a set amount of money paid back over a specific period of time. Your car loan, for example, is an installment loan. You may have agreed to pay it back at $300 per month for four years. Once that's done, it's paid off, and that line of credit no longer exists.
The difference between revolving credit and installment loans is significant because it appears differently on your credit score. Racking up a lot of debt on your revolving credit can negatively affect your score. Typically, borrowers should aim to owe 30 percent of their credit limit or less.
How to Use Revolving Credit to Your Advantage
Being a responsible borrower is the key to taking advantage of your revolving credit options. We outline some of the things you can take advantage of below.
Manage Your Cash Flow
Suppose you have an irregular income or must pay lots of monthly expenses. In that case, a revolving line of credit can help. Instead of constantly worrying about how much is in your account, you can borrow against your line of credit or credit card and then pay it all off at the end of the month.
Plan Ahead If You Need A Loan
If you'll need a loan or line of credit, it's also an excellent time to pay down the debts you owe.
Maintaining a high balance might disqualify you from certain loan agreements or lead to a higher interest rate offer.
Control Your Spending
People get in trouble with their credit account when they let spending get out of hand.
But if you can keep it under control, that's awesome! Sometimes, you can borrow money and not even pay interest if you get your balance back to zero quickly enough.
There are other perks to controlling your spending with revolving credit.
For example, many rewards cards offer 1 or 2 percent cash back on purchases. You get half when you buy and the other half when you pay it off.
According to the IRS, that money is not only free—it's also not counted as taxable income. Some rewards programs offer miles or hotel stays instead of cash. Look into what fits your lifestyle!
Pay More Than The Minimum
You always want compound interest on your side with revolving credit lines. The best way to do that is by paying more than your minimums each month.
For example, if you took out a $5,000 line of credit at a 14 percent interest rate and only paid the minimum of $200 on it each month, it would take 2.5 years to pay off.
In that time, you'd end up paying $946 in interest! If you paid $800 a month, you'd be done in 7 months with only $223 in interest.
The power of compound interest shouldn't be taken lightly. There's a reason Einstein called it the eighth wonder of the world.
Disadvantages of Revolving Credit
Like any financial decision, there are potential drawbacks to using revolving credit.
Here are some downsides you should consider when deciding if it's the right option for you.
Failing To Pay Back What You Borrow Each Month
Revolving credit certainly has its advantages. It's flexible and helpful in many situations. But not paying your debts back can stink. Some companies, especially credit cards, set ruthless terms for those who borrow and don't pay back.
The average penalty fee is just under 28 percent APR on your credit card. That's a steep number that could be 2 or 3 times your average interest rate.
Easy To Make Impulse Purchases
Sometimes it's hard to remember that your line of credit constitutes real money. For some, it's easier to rack up charges than see their savings account get low or their cash disappear.
Revolving lines of credit aren't great if you tend to impulse spend or shop emotionally. You could quickly put yourself in a position that's hard to come out of, accruing hundreds in interest each month.
Missing Payments Can Damage Your Credit Score
Missing payments can hurt your future self, too. Besides owing a lot more money than before, creditors can report your delinquent accounts to the three credit bureaus.
A bad credit score makes it harder for you to borrow money in the future. Most delinquency cases for consumer credit stay on your credit for up to seven years.
Getting a mortgage, taking out another personal loan, or even getting a new store credit card could be more challenging in the future. And they'll also likely charge you higher interest rates as a result of your poor payment history.
How Can Revolving Accounts Impact Your Credit?
Your credit score consists of a few factors:
- Payment history
- Accounts owed
- Length of credit history
- Credit mix (ratio of consumer debts vs. business debt, etc.)
It isn't an equal weight, either. Payment history makes up the largest part of your score. So if you miss payments frequently, borrowing money could significantly impact your credit score.
It is, however, possible to boost your credit score. In some cases, you can dispute claims sent to the bureaus and have them taken off your account.
But for most people, it requires merely buckling up and building their credit back up from scratch. This can take years, and even with a flawless record of five years of repayment, those old unpaid debts can still come back to haunt you.
Revolving Credit Is A Useful Financial Tool
Hopefully, that helps clarify the question, What is revolving credit? From credit cards to HELOCs to gas station rewards cards, revolving credit is a flexible form of debt. You can make the minimum payment on it as you see fit and borrow more in the future.
Joseph Priebe takes pride in assisting audiences with his articles to help them make sound financial decisions.
With over ten years of experience writing financial content his goal at CASH 1 has always been creating engaging and easy-to-digest information for anyone searching for immediate or long-term monetary solutions.
When Joseph is not writing about personal finance, you can find him photographing the Southwest United States with his 4x5 Graflex Crown Graphic camera. He is based in Phoenix, Arizona.