Wouldn’t it be great to have access to a steady source of funds that was continually replenished? Well, you can. It’s called revolving credit, and it’s available at banks, credit unions, and other financial institutions. However, it doesn’t renew itself — that’s done by you. Now, you may be asking, “What is revolving credit exactly?”
According to consumer credit company Experian, credit is “borrowed money that you can use to purchase goods and services when you need them.” This borrowed money must be paid back on a mutually agreed-upon date, along with any interest or added fees.
There are different types of credit available, but the most common one is known as revolving credit. Almost everyone has some form of revolving credit — a credit card, a home equity line of credit (HELOC), or a personal or business line of credit.
In this post, you’ll learn everything you need to know about revolving credit, how it differs from other types of credit, and what it can mean to your credit score.
What Is Revolving Credit?
Revolving credit is a type of credit that gives borrowers access to a certain amount of money, the maximum of which is called the total credit limit. You’re free to withdraw any amount at any time within this credit limit.
As you continue to withdraw money, two things happen — your balance increases, and your credit limit reduces by the amount withdrawn. For example, say you have a credit limit of $50,000. If you withdraw $20,000, then your balance automatically increases to $20,000 and your credit limit reduces to $30,000.
To get your credit amount back up, you have to reduce your balance by paying down the withdrawn amount. Aside from the minimum monthly payment (usually a percentage of the balance) set by the lender, you can pay any additional amount to reduce the amount you owe.
With revolving credit, borrowers can opt to carry over, or revolve, any amount above the required minimum payment to the next month or billing cycle. This revolving balance, however, usually incurs interest or finance charges, depending on the bank, creditor, or financial institution.
Any time a payment is made toward the balance, an equal amount goes back to the available credit. If the entire balance is paid (along with any other charges), the credit limit returns to its maximum amount.
In this manner, revolving credit enables you to withdraw and repay from your credit line any number of times until the account is officially closed or expired.
How Revolving Credit Works
As with most financial concepts, it’s often easier to understand with an example. Here’s one to help answer the question, “What is revolving credit?”
Let’s say you just secured a new credit card with a credit limit of $2,000 and an annual percentage rate (APR) of 24.49% on purchases. During the first month, you spend $1,000. This leaves $1,000 left on your credit limit.
When your first month’s billing statement arrives, you can either pay the whole $1,000 and regain your $2,000 credit limit, or you can pay the minimum amount listed on the statement. If you decide to pay the minimum, which in this case is a hypothetical $50, you are left with a remaining balance of $950 and an available credit of $1,050.
During your second month, you spend $500, which increases your balance to $1,450 and reduces your credit to $550. When you receive that month’s billing statement, you once again choose to either pay the whole balance of $1,450 (which will likely be higher, given any added interest or finance charges), or pay the listed minimum (which will also be higher, given the greater balance). If you choose to pay the whole amount, you are now left with a zero balance and the original credit limit of $2,000.
A Point of Interest
While the beauty of revolving credit is that the balance can be carried over to the next month or billing cycle, it’s always best for you to pay the full balance and save on interest charges whenever possible.
To figure out how much interest you’ll have to pay on your balance, you need to convert your APR to a daily rate, which is called a daily periodic rate (DPR). This is easily done by dividing the APR by 365 or 360, depending on the number of days used by the financial institution.
In this case, the DPR equals 0.067% (24.49% divided by 365). When applied to the balance of $950, this amounts to 64 cents in daily interest.
This 64 cents is added to your balance on the first day, resulting in a new total balance of $950.64. Then, using this new balance, the daily interest will be calculated again for the following day. This goes on every day, adding on any new withdrawals and deducting any payments made, until your next monthly statement.
This does require a bit of calculation, so if you’d rather take the easier route, there are a number of convenient online calculators you can use, such as these from Consumer Credit and Card Rating.
Keep in mind that these are simple averages. Your balance changes every time you make a withdrawal or payment. However, even having a rough idea of how much interest you’ll have to pay can help you keep tabs on your personal finances.
Revolving Credit vs. Non-Revolving Credit
Revolving credit differs from non-revolving credit in almost every way.
Non-revolving credit, or installment credit, is very cut-and-dried — a fixed amount of money is borrowed upfront, usually for a specific purpose, and is then paid back in predetermined installments over a period of time.
Once all the payments have been made and the balance reaches zero, the account is considered closed. It doesn’t revolve and the money can’t be withdrawn again. Should the borrower need more credit, you will need to apply for another loan. Examples of this are home loans, car loans, and student loans.
Non-revolving credit is generally harder to qualify for and may require the borrower to put up some form of collateral. However, this helps lower the risk for the lender and lets you borrow at lower interest rates (based on the lump sum at the start of the term) and at much higher amounts. For instance, while you can finance a house or college education with a non-revolving loan, it would be a bit harder to do so with a revolving credit card.
In contrast, revolving credit offers much more flexibility. There is no specific purpose for borrowing the money (at least not one required to apply) and no fixed figure or number of installments.
Whatever you withdraw is deducted from your credit limit, and whatever you pay back is returned to the credit limit. This goes on repeatedly until the account is closed.
As long as you follow the terms of the credit agreement, namely to stay within the credit limit and pay at least your minimums on time, you are free to borrow and pay back as much and as often as you’d like.
Keep in mind that the freedom of revolving credit often comes at a higher interest rate as compared to non-revolving credit. In 2019, for example, the average APR for a car loan is 3–10%, while the APR for a credit card ranges from 14–22%.
How Revolving Credit Affects Your Credit Score
Revolving credit can affect your credit score in several ways. The first way comes before you even have an account. Whenever you apply for credit, the financial institution typically checks your credit history using what’s referred to as a hard inquiry, which may lower your credit score by a few points.
More important to credit, however, is how you handle the credit you’re given. If you pay at least your minimums on time, this indicates that you are financially responsible and it will help boost your credit score. If you are late or fail to make your required payments, this lowers your credit score and will likely lead to the termination of the account.
Another important factor is how much available credit you actually use, also known as your credit utilization ratio. High utilization is usually a sign that the borrower is spending above their means, and therefore, needs credit to pay for their expenses. In this case, the borrower may have trouble making payments and is seen as a higher risk, especially when applying for any other loans or lines of credit in the future.
To prevent this from happening, a good rule of thumb is to keep your credit utilization below 30%. For example, the maximum credit utilization on a credit limit of $5,000 would be $1,500. As long as the balance stays below this number, then credit utilization is at the recommended rate for a good credit score.
Which Type of Credit Is Best?
Revolving and non-revolving credit are two great options to finance your purchases — as long as you manage your accounts correctly. Revolving accounts are ideal for regular, manageable expenses. Its open and revolving nature makes it a convenient source of cash for anything you may need to purchase at the moment.
In contrast, non-revolving credit is better for a large, expected expense (i.e., buying property or vehicles). Since this type of credit offers lower interest rates and a fixed repayment schedule, it’s a clear way to finance long-term purchases.
Credit Where Credit Is Due
Now that you have the answer to “What is revolving credit?” and know about the different credit options available, you can better manage your finances.
Revolving credit can be a useful way to pay for daily or recurring expenses, as it allows you to withdraw any amount anytime without prior approval (as long as it’s within your credit limit).
Even those who are more than capable of paying with cash can benefit from having a revolving credit account. Revolving credit helps you raise your credit score, provides assurance to financial institutions that you are solid candidate for any potential future loans, and helps you maintain good financial health overall.
Plus, having access to revolving credit as a ready means of payment anytime you need it — whether you’re in a pinch or just prefer to maintain a steady cash flow — is invaluable.