Understanding Revolving Credit

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Your car needs a new transmission. Termites have infested your basement. Or your son broke his arm skateboarding. The bill for it comes to $4,000, but you've only got $2,000 in your bank account. What do you do? Revolving credit can come to the rescue. Revolving credit is a credit account that lets you repeatedly borrow money up to a set limit and pay it back over time. It can give you a financial cushion for emergencies and help you manage your money. Here's what you need to know about revolving credit.

How Does Revolving Credit Work?

A revolving credit account sets a credit limit—a maximum amount you can spend on that account. You can choose either to pay off the balance in full at the end of each billing cycle or to carry over a balance from one month to the next, or "revolve" the balance.

When you revolve a balance, you'll have to make a minimum payment each month. This may be a fixed amount, such as $25, or a percentage of your total balance, whichever is higher; you can find specifics in the fine print of your revolving credit agreement. You'll also be charged interest on the balance that is carried over from month to month. (The exception is a credit card or line of credit with a 0% interest introductory period.) You may also have to pay other fees, such as annual fees, origination fees or fees for missed or late payments.

Examples of revolving credit include credit cards, personal lines of credit and home equity lines of credit (HELOCs). Credit cards can be used for large or small expenses; lines of credit are generally used to finance major expenses, such as home remodeling or repairs. A line of credit allows you to draw money from the account up to your credit limit; as you repay it, the amount of credit available to you rises again.

How is Revolving Credit Different from Installment?

There are two major types of credit: revolving credit and installment credit. Installment loans allow you to borrow a set amount of money and repay it over a specified period of time in fixed monthly installments. Auto loans, student loans and mortgage loans are examples of installment loans. Once you pay off an installment loan, the account is closed; you can't go back and borrow the same amount again. With revolving credit, as soon as you pay down your balance, you can draw or spend again within your credit limit.

Installment loans have their pluses and minuses.

The big plus: You always know how much you'll be paying each month, which makes it easier to budget and plan.

The big minus: Installment loans aren't as flexible as revolving credit. If money is tight one month, you can't make a minimum payment on your mortgage or car loan—you have to make the full loan payment. But you can pay just the minimum on your revolving credit accounts.

How Do Revolving Accounts Affect Credit Scores?

Like all types of credit, revolving credit accounts can either hurt or help your credit scores depending on how you use them. If you have little or no credit history—say, you just got out of high school or college—getting a credit card, using it for small purchases and paying the bill in full and on time every month is a great way to start building a good credit score. (Without a credit history, you may need to get a starter credit card.)

Making your payments on time is the single biggest factor in your credit score, so be sure to meet your payment due dates. See if it's possible to set up autopay so you never miss a payment.

Ideally, you should also pay your credit card balance in full every month. If you can't manage to do that, aim to keep the balance below 30% of your available credit. Credit scores are highly sensitive to your credit utilization ratio—the amount of revolving credit you're using relative to your total credit limits—and a utilization ratio over 30% can hurt your credit score. To figure out your utilization rate, divide your total credit card balances by your total credit limits. For example, if you have a credit card with a $9,000 limit, a $3,000 balance would put you at 30% utilization.

Opening and closing revolving accounts can also affect your credit score in several ways.

  • Diversifying your credit mix: Having a mix of different types of credit is a factor in your credit score, and showing that you can manage various kinds of credit can help build a strong credit history. If your only current credit account is an installment loan—for instance, you just graduated from college and are paying off a student loan—getting a credit card will improve your credit mix.
  • Causing hard inquiries: When you apply for revolving credit, the lender requests your credit file from the credit bureaus, resulting in a hard inquiry on your credit report. Hard inquiries cause a dip in your credit score, though usually only for a few months. (The inquiry will remain on your credit report for two years.) In addition, applying for several credit cards or loans at once can hurt your credit score by suggesting to credit scoring models such as FICO that you're in financial trouble. The one exception is when you're rate-shopping for a mortgage or other loan; in this case, the credit scoring models typically treat those inquiries as a single event.
  • Closing accounts: Closing a credit card that you're not using anymore might sound like a good idea, but since it reduces the amount of credit you have available to you, it may also push your credit utilization ratio over 30%. Even if the card has a zero balance, keeping the account open can help your credit score.

A Useful Financial Tool

Whether you use a credit card to conveniently pay your cable bill each month or take out a HELOC to finance your new rec room, revolving credit offers a useful way to pay for both ongoing purchases and one-time expenses. When you use it responsibly, revolving credit can help you manage your cash flow and build a good credit score—both of which are key to a healthy financial life.

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