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Have you ever used a credit card? If so, you've used revolving credit. Revolving credit can offer a convenient way to finance large expenses, make everyday purchases and earn rewards. Revolving credit grants you a credit limit, which you can spend up to, repay and spend up to again. Understanding how revolving credit works can help you get the most from your revolving credit accounts. Here's what you need to know.
How Does Revolving Credit Work?
When you open a revolving credit account, you'll be given a credit limit—the maximum amount you can spend on the account. At the end of each billing cycle, you'll receive a statement showing a balance, or the total amount you owe. You then have two options:
- You can "revolve," or carry over, part of the balance to the following month. You can't carry over the entire balance; you'll have to make at least a minimum payment. This will be specified in your revolving credit agreement and may be a set amount, such as $25, or a percentage of your balance. Unless the credit account has a 0% introductory interest period, any balance you carry over begins to accrue interest, which gets added to your total balance.
- You can pay off the balance in full by the payment due date, and no interest will accrue.
Common Types of Revolving Credit
The most common types of revolving credit are credit cards, personal lines of credit and home equity lines of credit.
- Credit cards: You can use a credit card to make purchases up to your credit limit and repay the credit card issuer for the amount you spent, plus any fees and interest. If you pay your balance in full before the end of the grace period (typically between 21 and 30 days after the billing cycle closes), no interest will accrue. Many credit cards also let you earn rewards based on your spending. Some cards offer other benefits, such as extended warranties for products purchased with the card.
- Personal line of credit: Some banks and credit unions offer personal lines of credit, which allow you to borrow money up to your credit limit. During the "draw period," typically three to five years, you can withdraw money or make purchases by using a bank card or writing checks. You pay back the amount borrowed in variable monthly payments, ranging from the minimum payment required to the entire balance. As you repay money, your available credit is replenished. During the repayment period, which usually lasts three to five years after the draw period ends, you'll repay any remaining balance by making fixed monthly payments.
- Home equity line of credit (HELOC): A (HELOC) works like a personal line of credit, but uses your home as collateral. HELOCs let you borrow against your home's equity (the amount by which its appraised value exceeds the unpaid balance on your mortgage). Generally, HELOCs have five- to 10-year draw periods and 10- to 20-year repayment periods. Most HELOCs let you borrow between 60% and 85% of your home's equity.
Revolving Credit vs. Installment Credit
There are two primary kinds of credit: revolving credit and installment credit. With installment credit, you borrow money in a lump sum, then repay the amount borrowed (plus interest) over a set time period in fixed monthly installments. Common types of installment credit include home mortgage loans, auto loans and student loans. Unlike revolving credit, you can't borrow more against an installment loan as you pay it down. Once you pay off the loan in full, your account is closed.
Installment loans have pros and cons compared with revolving credit.
Installment Credit Pros
- Predictability: Payments stay the same every month, which can make it easier to budget.
- Potential for savings: You may be able to save on interest by paying the loan off early.
Installment Credit Cons
- No flexibility: You have to pay the same amount every month, which might become difficult if your financial situation changes.
- Can be risky: You could lose your car, home or other collateral if you don't make the payments on a secured installment loan.
How Do Revolving Accounts Affect Credit Scores?
As with all credit, the way you handle revolving credit can either help or hurt your credit score.
How Revolving Credit Can Hurt Your Credit Score
- Missing payments: Since payment history is the biggest factor in your credit score, a late or missed payment on a revolving credit account can negatively affect your credit.
- Credit utilization ratio: Your credit utilization ratio, or the amount of revolving credit you're using relative to your credit limits, is a major factor in your credit score. Using more than 30% of your available credit on a single revolving account and across all your revolving accounts can have a greater negative effect on your credit score than a lower credit utilization rate would. If you have a credit card with a $10,000 limit, for instance, try to avoid carrying a balance of more than about $3,000. The same goes for having high balances on multiple cards: Carrying a $5,000 balance on a card with a $10,000 limit and a $2,000 balance on a card with a $6,000 limit gives you a total credit utilization ratio of 43.5%, which could hurt your credit.
- Closing accounts: Closing an account increases your credit utilization ratio by reducing the total amount of credit available to you. Even if you're not using a revolving credit account anymore, closing the account could hurt your credit score, so it's best to keep it open.
- Hard inquiries: Applying for any type of credit causes a hard inquiry on your credit report, which can make your credit score dip temporarily. If you plan to get a mortgage, auto loan or other major loan soon, avoid applying for any other new credit.
How Revolving Credit Can Help Your Credit Score
- Making on-time payments: Paying your bills on time can help improve your credit, since timely payment is the primary factor in your credit score. Consider setting up autopay for at least the minimum payment on revolving credit accounts to avoid late payments.
- Building a credit history: Without credit accounts, you won't have a credit score. Obtaining a credit card and paying off the balance on time each month is an easy way to start building a history of responsible credit use. Credit cards tell your lenders a lot about how well you can manage debt because they give you the flexibility to decide how much you will charge and how much you will repay each month.
- Diversifying your credit mix: Having both revolving and installment credit accounts can boost your credit score. If you only have installment credit (such as a student loan and a car loan), opening a revolving credit account will diversify your credit mix and may improve your credit score.
The Bottom Line
Revolving credit can be a useful tool to pay for both day-to-day purchases and one-time expenses. A good credit score can help you qualify for more favorable revolving credit terms, such as lower interest rates. Check your credit report and credit score before applying for credit. Depending on what you find, it may be worth taking some time to improve your credit score before you apply.