Revolving credit is a line of credit that individuals and corporations can take out from a lending institution to be used as needed over a period of time. A line of credit varies in the total amount that is made available to the consumer, but is flexible in how much is borrowed and how often.
For example, revolving credit is a good choice for individuals who are remodeling a home and need a varying amount of money to complete the projects. For corporations in their start-up phase, they might find a revolving line of credit a good solution to monthly fluctuations in expenses.
Glossary of Credit Terms
It is important to be familiar with credit terminology in order to determine which type of credit or line of credit is right for you and your needs.
Below is a list of some of the most commonly used words to help you build a basic knowledge of financial terminology.
- Credit: a contract in which a borrower receives something of value now and agrees to repay the loan with interest.
- Line of credit (LOC): an arrangement between a financial institution and a consumer that establishes a maximum amount to borrow, allowing the consumer to access the funds on an as-needed basis.
- Cash flow: a revenue or expense stream that changes over a period of time, usually due to business operations and investing.
- Default: the failure to promptly pay interest or principal according to the terms of the loan agreement.
- Financing: the act of providing funds for business or personal activities, making purchases or investing.
- Open-ended credit: a term that is used interchangeably with revolving credit.
- Secured loan: a loan that is backed by collateral (a car, house or piece of property).
- Unsecured loan: a loan that is not backed by collateral.
How Does Revolving Credit Work?
Revolving credit most commonly refers to a credit card. When you receive a credit card, you are taking out a line of credit. The maximum amount you can borrow is known as your credit limit. The ideal way to use the system is to make credit card purchases on an as-needed basis and to pay off the balance at the end of each month.
When you do not pay off the balance in full every month, the bank charges interest on the remaining balance. Interest rates can range from 10 to 28 percent, based on the credit line provider. While about 40 percent of cardholders pay their full balance off each month, a large number of Americans get caught in the revolving credit trap and are stuck paying a significant amount of interest over time.
The Difference between Revolving Credit and a Loan?
There is a difference between revolving credit and loans. Revolving credit is an open-ended credit line. There is not a set monthly payment, and the length of the credit is ongoing. A loan is also known as a close-ended credit option. This means that the loan is a fixed amount, has a set time period for payoff and specifies monthly payment amounts.
There are advantages and disadvantages to revolving credit. For example, a person who has a seasonal job could benefit from revolving credit. He or she would be able to purchase what is needed during the slow time of year, with intentions of paying the balance off once the paychecks start coming in consistently. If done properly, this scenario is the ideal way to use revolving credit.
On the other hand, a person who gets a credit card with a limit of $10,000 and uses the card until it is maxed out, without a specific repayment plan in place, would be at a huge disadvantage when using revolving credit. Interest begins to stack up, and you will pay the credit card company substantially more than you borrowed.
Revolving Credit and Your Credit Score
Your credit score also plays a big role in revolving credit limits and the interest rates associated with them. The higher your credit score is, the more flexibility you have in choosing a credit line that will be most beneficial to you and your financial goals.
Revolving credit can benefit consumers in many ways when it’s used within certain contexts and for a specific purpose. But there are also many ways that the flexibility of “buy now and pay later” can trap consumers and take a toll on their credit and ultimately their lives. Revolving credit must be used wisely, and consumers need to have knowledge of how a line of credit works and the risks associated with this type of financing.