Revolving Credit: What Is It, And How Does It Work?
A good credit score isn’t just something to brag about, it’s a way to show lenders that you’re a responsible borrower. This can help get you a lower interest rate and better terms on a loan. Credit can impact your financial life in a big way, so it’s important to know what it takes to have what’s considered good credit, which is typically a score above 670.
There are a number of factors that go into a credit score:
- Payment history
- Total debt and amounts owed
- Credit utilization
- Age of credit
- Credit behavior and inquiries
- Types of credit
While all of these factors tell a piece of your financial story, the types of credit you have will show lenders how you handle different debts; so, it’s a good idea to diversify your credit. One type of credit you could have is revolving credit.
What Is Revolving Credit?
Revolving credit allows you to continuously borrow money up to a certain limit. The amount you owe is carried over month to month and changes whenever you make payments or borrow more money. When you make payments, more credit becomes available to you (up to the maximum). On the flip side, the more money you borrow, the less credit you have available to you. The unique thing about revolving credit is that, as long as you stay under your limit, you can continuously borrow money from that account without needing to get approved again.
How Does Revolving Credit Work?
Revolving credit has a maximum limit on what you can spend, or how much you can borrow. This is called a credit limit. You can borrow up to your limit, but once you do, no more credit is available to you. Once you make a payment, you’ll have credit available to use again. Whatever amount you pay back becomes available to borrow again.
Here’s an example: If you reach your $5,000 credit limit, you cannot borrow more money. This is often the reason your credit card may get denied when you try to use it. However, if you pay off $1,000 of your debt, you’ll have $1,000 available to you to borrow again.
While you can make payments to your revolving credit account whenever you want, there’s still a required minimum payment you must make each month. And, just like most debt, the amount you borrow will be charged interest. It’s important to remember, too, that interest rates on revolving credit are typically higher than other forms of credit. The terms and fees will depend on the type of revolving credit you get. The same goes for applying and qualifying for this type of credit. Some revolving credit is easier to qualify for than others.
Common Types Of Revolving Credit
There are a few types of revolving credit that are extremely common for consumers to use. The most common are credit cards and the home equity line of credit.
A credit card is a payment card given to you by a company or bank, called an issuer, that you use to make purchases on goods and services. The money you use to pay for such goods and services is borrowed from the issuer and expected to be paid back, whether in full or through minimum payments. If you pay the amount back before the grace period is over (typically around 30 days), you won’t be charged interest on it. Whatever you pay back will be made available to borrow again.
Getting a credit card can be fairly easy. After doing some research to determine which card is right for you, you’ll apply. The issuer will determine your creditworthiness by looking at your credit report. Prepare for a ding on your credit score as this will be considered a hard inquiry, which can have a negative impact on scores.
Home Equity Lines Of Credit (HELOCs)
A HELOC works like a second mortgage in which you borrow money from the equity you have in your home. This is a type of revolving credit because, instead of a lump sum of money, you are able to continuously borrow money from your equity, up to a certain limit. Depending on how much equity you have in the home, you may be able to borrow more money than a credit card. So, a HELOC may be more useful if you need to borrow a larger sum of money.
Getting a HELOC is a little more complicated than getting a credit card. For one, you need to have a home and equity in the home. Once you shop around and find the right lender, you’ll need to apply for the line of credit. Along with reviewing your credit report, the lender will also require such documentation as W-2s, paystubs, tax returns and information on your home to decide whether to lend you money and determine the terms of the loan. This will also count as a hard inquiry on your credit report.
Revolving Credit Vs. Installment Credit
There are two of the main types of credit you’ll encounter: revolving credit and installment credit. Unlike revolving credit, which allows you to continuously borrow funds, installment credit has a fixed borrowed amount that you get at one time and is paid off in monthly installments. This type of credit has a predetermined date or number of payments that the loan will be repaid. Repayment periods typically last anywhere from a few months to 30 years.
Since installment credit comes with a lower cost of borrowing than revolving credit in terms of interest rate, it is often used for large purchases, like a home or car. It can also be used to pay for tuition or to consolidate and pay down debts. The most common types of installment credit are student loans, auto loans and mortgages.
Uses For Revolving Lines Of Credit
There are a few reasons someone may want to use revolving credit instead of installment credit. Credit cards are good for small purchases and can come in handy in times of emergencies, since you can borrow the money fast, without needing approval (as long as you aren’t at your credit limit). HELOCs are popular for home maintenance and upgrades since borrowers won’t have to make large monthly payments on these projects, which can also help increase your home’s value and give you a return on your investment.
Benefits Of Revolving Credit Accounts
Among the uses for revolving lines of credit, there are also advantages to opening up a revolving line of credit.
Rapid Access To Funds
As stated before, revolving credit allows you to continuously borrow money as long as you stay within your credit limit. This can allow you to access funds right when you need them, in case of an emergency. While this is convenient, it should be used as a last resort. You should still have other resources to pay for things if your current financial situation is tights. These may include a budget, a second stream of income and a healthy emergency fund.
A Diversified Credit Mix
Adding a revolving credit account to your credit collection (which should include installment credit as well) will help give you a diversified mix of credit, which can help improve your credit score and show lenders that you’re able to handle multiple kinds of debt.
Drawbacks Of Revolving Credit Accounts
Although there are positives associated with revolving credit, these accounts can also have a few negative impacts on those who use them.
They Can Damage Your Credit Score
Like any type of credit account, revolving lines of credit can be harmful to your credit score if you don’t practice responsible borrowing. Making late payments, missing payments, maxing out your credit card line or applying for too many credit cards can all have a negative impact on your score. To make sure this doesn’t happen, only borrow what you know you can pay back right away, make timely payments, only apply for credit you need, monitor your score regularly and see where you can make improvements.
There are certain fees that can accompany such revolving lines of credit as credit cards and HELOCs. Many credit cards have an annual fee, along with interest that’s charged on any balance you carry. There can also be late fees, balance transfer fees, cash advance fees and charges for going over your limit. Not all credit cards are the same, and each one has different fees and terms, so it is important to review the terms of your credit card before applying for it.
In the same way, HELOCs also have added fees. These may include origination fees, annual fees, variable interest rates and cancellation fees. When reviewing your HELOC terms, ask questions, see if there are any fees you can have waived if possible and make sure you understand all terms of the loan before signing.
The Bottom Line
By allowing you to continuously borrow money, revolving credit can offer flexibility and faster access to funds when you need them. While revolving credit can also help diversify your credit mix and improve your score, it can also hurt your credit score if you’re not careful. Make sure you educate yourself on revolving credit, have a strong financial standing and that your credit score is in good condition before opening a new line of credit. Use Rocket HQSM’s credit monitoring service to see where your credit stands and to stay updated on future score changes to your report.
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