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Revolving credit is when you repeatedly borrow and repay a portion of funds from a credit line extended to you from a lender.
Credit cards are a perfect example of revolving credit as opposed to a personal loan, where a financial institution releases a lump sum of cash to a borrower that has to be repaid in equal installments over a defined period of time, which is called non-revolving credit.
- How does revolving credit work?
- Types of revolving credit
- How does revolving credit affect your credit score?
- Best ways to manage revolving credit
How does revolving credit work?
Since credit cards are a classic example, we’ll use them to explain how revolving credit works.
When you are approved for a new credit card, the card issuer gives you a credit line, or credit limit, of a certain amount of money. That credit limit could be a couple hundred or thousands of dollars.
You are allowed to borrow up to your credit limit in any given billing period. Your credit card will also come with an interest rate, or APR, which is what the card issuer will tack on to any unpaid balance that is “revolved” or carried over into the next billing cycle.
When you use your card for purchases, you are borrowing against that credit line. The card issuer then sends you a monthly statement showing how much you have charged to the card, which is called your balance, plus any interest charges and fees.
You can choose to pay your balance in full, pay a portion of it, or just make the minimum payment.
If you choose to pay the balance in full every month, you can avoid being charged interest, but if you only pay a portion of the balance, you will be assessed interest on the amount that is carried into the next billing cycle. If you just pay the required minimum payment, know that you’ll just be paying 1% to 2% of the principal balance, plus any fees and monthly interest.
Your payment amount, minus any fees or interest, is then added back to your credit line, allowing you to borrow against it once more.
Types of revolving credit
In addition to credit cards, here are two other primary types of revolving credit:
- Home equity line of credit
- Personal line of credit
Home equity line of credit or HELOC
A HELOC allows a homeowner to borrow against a certain percentage of the equity built up in their home. This is also a secured loan, meaning that your home serves as collateral and if you don’t repay what you owe, the lender can seize your home. HELOCs, like credit cards, generally come with variable interest rates, which means the interest rates rise and fall in tandem with increases or decreases in the prime rate.
Like credit cards, you can borrow and repay from the HELOC on a monthly basis. However, HELOCs do come with “draw periods” where once that draw period ends, the borrower will be required to repay what’s borrowed during a set repayment period.
Personal line of credit
An unsecured personal line of credit (LOC) is issued by a bank or credit union and comes with a variable interest rate. Interest rates on personal LOCs are generally lower than credit cards, but higher than HELOCs, and reserved for customers with good to excellent credit scores. How they differ from credit cards is that the line of credits does have a time expiration date.
When you borrow funds from a personal LOC, you’ll only pay interest on the amount borrowed, and you can only borrow as much as your credit limit allows. Once you repay the amounts borrowed, those funds are added back to your credit line from which you can borrow again. Monthly minimum payments are required.
How does revolving credit affect your credit score?
Credit utilization, which is how much of your credit line you’re using during each billing cycle, is the second highest factor (at 30%) that impacts your credit score. Payment history has the biggest impact (at 35%) of your credit score.
Credit experts recommend using less than 30% of your credit limit at any given time to optimize your credit score. For example, if you have a credit card with a $1,000 credit limit, don’t charge more than $300 to your card in any given month. And if you do charge more than that, pay down that balance as soon as possible.
Maxing out your credit line by charging up to your credit limit will hurt your score as well as make you look risky to lenders if you’re looking to apply for new credit. That’s why it’s important to keep your credit card balances under control.
Know that credit utilization is figured not only for an individual revolving credit lines, but across all your revolving credit lines. To calculate your credit utilization ratio across multiple lines, here’s the formula:
Add up all your balances divided by the total of all your credit limits = credit utilization ratio
|Card A||Card B||Total|
|Credit utilization ratio||25%||90%||47%|
In contrast, a non-revolving credit account, such as a mortgage or car loan, doesn’t impact your credit utilization ratio, but any late payments will be reported to the credit bureaus.
Best ways to manage revolving credit
Even those with the best intentions can get into trouble with a revolving line of credit, especially because paying the entire balance off at the end of a billing cycle isn’t required (unless you have a charge card, which generally is non-revolving). And interest charges add up over time to carried-over balances, making it even more difficult to whittle away what you owe.
Here are some tips to keep revolving credit accounts under control:
- Have a repayment plan in place. With credit cards in particular, don’t charge more than you can repay in a month. If you need to spread out payments on a large expense, you may want to consider a credit card offering a 0% intro promotion where interest charges are waived for a certain period of time. Otherwise, create a payoff plan and avoid using the card for new purchases until the balance is paid off.
- Always pay more than the minimum payment due. A minimum payment barely makes a dent in the principal amount owed as any interest charges are added into it. The more you can pay above the minimum payment will go toward your balance and keep your debt from spiraling out of control.
- Don’t max out your credit line. Charging up to your card’s credit limit will not only make it difficult to pay off, but will also hurt your credit score by reporting a high credit utilization ratio. If you do need to use the card to make a large purchase, pay it off as soon as possible to bring your utilization in line with the recommended less than 30% of your credit limit.
- Never miss a payment. Late payments of more than 30 days stay on your credit reports for up to seven years and can really do some credit score damage. Plus, you’ll be hit with late payment fees and, if you’re more than 60 days late, a penalty APR. Know that if you are hit with a penalty APR, if you make six consecutive payments on time, you can request that your original APR be restored. The best way to avoid making late payments is to set up autopay with either your bank or credit card.