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- The term “revolving credit” refers to things like credit cards and lines of credit – it’s money you can borrow, pay back, and then borrow again.
- Compared to installment loans, such as mortgages or auto loans, revolving credit accounts typically come with higher interest rates.
- It can be easy to spend more than you can afford with a revolving credit account, so it’s essential to manage your expenses and pay off your debt in full each month.
There are three types of credit: open credit, installment loan and revolving credit.
Installment loans are often large sums of money borrowed all at once that you repay over a period of time in relatively small amounts. These are often used for major purchases like a house or a car. Open credit allows you to borrow up to a certain limit, but the full amount must be repaid at the end of a billing period. These are often used for recurring bills, like utility bills or phone bills.
But for everything in between, you have revolving credit. Revolving credit allows you to make purchases when you don’t have cash on hand. Here’s how it works:
What is revolving credit?
Revolving credit allows you to borrow money up to a certain limit whenever you want. Each time you make a purchase, the amount is subtracted from your total credit limit. As you make payments, your credit limit goes up, so you can turn around and borrow more.
The most common example of revolving credit is a credit card. If you have a credit card with a credit limit of $10,000 and you make a purchase of $2,000, you only have $8,000 left to spend. Once you repay the $2,000, your limit will go back up to $10,000.
Lines of credit are another example of revolving credit. Personal and home equity lines of credit (HELOCs) are common choices for those who need to borrow large sums of money on a flexible schedule.
Revolving credit offers greater flexibility than other types of credit. They don’t come with fixed monthly payments or repayment dates like loans, although you do have minimum monthly payments. Although you can pay off your entire balance at once, you don’t have to. However, keep in mind that if you choose not to, you will be charged interest.
Types of revolving credit
Revolving credit comes in two types: unsecured credit and secured credit.
Secured credit is credit that is backed by collateral, such as a security deposit or an asset such as a car or house. Your secure revolving credit borrowing limit is proportional to what you provide as collateral.
It is less risky for lenders since they will be compensated if you cannot repay your debts. Because there is less risk, your interest rate under secured credit will generally be lower. A common example of secured revolving credit is a secured credit card.
In contrast, unsecured revolving credit is not backed by anything. Even if you, as a borrower, do not risk losing anything if you do not repay your debts, your interest rates will be higher. Most traditional credit cards are forms of unsecured revolving credit.
Advantages and disadvantages of revolving credit
Like any financial product, revolving credit has its advantages and disadvantages.
The advantages of revolving credit
- The ability to spend what you need: If you have a credit card with a credit limit of $10,000, you don’t have to spend all of that $10,000 if you don’t want to. You can spend as little or as much as you need.
- Control how you repay your account: You can choose to pay off your account in full each month, or you can pay only the minimum balance or any amount in between (although you pay interest).
- A sustainable source of credit: With a credit card or other revolving credit account, you won’t have to ask for a new amount each time you need money like you would with a loan.
Disadvantages of revolving credit
- Higher interest rates: Revolving credit accounts usually come with higher interest rates than loans. Interest can become very problematic if you don’t pay your account in full each month.
- Costs: Some revolving credit accounts require you to pay an annual fee, origination fee, or other fee.
- Debts and degraded credit score: If you don’t repay your accounts on time and in full, and you spend more than you can afford, you could find yourself in debt with a downgraded credit score.
How does revolving credit affect your credit score?
When calculating your credit score from your credit report, FICO and VantageScore, the two most popular credit score models, factor types of credit into your overall score. Your combination of credit accounts makes up 10% of your FICO score, while VantageScore groups credit types and credit length into one category, which makes up 21% of scores.
That means lenders like to see you can control multiple types of credit, the same way colleges like students who can balance school and a sport or other extracurricular activity. For example, you may already have student loans and a car loan. If you can add a credit card to this mix and pay it off regularly, it can improve your credit score. In the eyes of a lender, you become a safe bet when they let you borrow money.
Revolving credit also comes into play when looking at credit usage, which accounts for 30% of FICO scores and 21% of VantageScore calculations. Credit usage is the ratio of the credit you are currently using to your total available credit. This should stay below 30%, although the lower your utilization the better.
The latest models from VantageScore and FICO, 4.0 and 10T respectively, consider trending credit data. Trend data is a method of predicting future behavior by looking at past data. In the case of credit, this means reviewing your revolving credit account balances over the past 24 months to predict how you will make future payments.
How to use revolving credit
Revolving credit can be a useful financial tool for building your credit history, if used correctly. To avoid getting into trouble with revolving credit, follow these tips.
Control your expenses
If you have access to a large credit limit, it can be tempting to live life to the fullest and spend more than you can afford, but avoid this impulse.
Use revolving credit responsibly by only charging what you can afford to pay in full each month. This lets you take advantage of rewards and points on credit cards and boost your credit score without going into debt.
Pay more than your minimum payments
Getting into the habit of only making minimum payments can lead to a cycle of debt, since you will have to pay a lot of money in interest. Strive to pay your balance in full each month. If you can’t afford to pay the full balance, paying more than the minimum can at least help you save on interest.
Depending on how you use it, revolving credit can be your best friend or your worst enemy. To avoid debt and keep your credit score in tip-top shape, be extra careful whenever you use a credit card, retail card, line of credit or other form of revolving credit.
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