Revolving Credit: What It Is & How It Works

Credit cards are a type of revolving creditRevolving credit is a loan with a predetermined spending limit that automatically renews as the debt is paid off. Credit cards are the most popular example of revolving credit and Americans are awash in debt because of them.

Despite an improving economy, households with credit card balances owed an average $9,333 in early 2018, with many living precariously close to going broke. Overall credit card debt in the U.S. rose $50 billion in 2017, pushing the total over the $1 trillion mark.

The culprit is revolving credit, a terrific tool for some but a snake pit for others who borrow excessively and fail to pay off their balances each month. Those who don’t pay in full each month face high interest rates on unpaid balances. It’s lucrative for the lenders and very expensive for borrowers.

Credit card issuers use credit lines to limit your spending. A credit line sets a maximum on what you can spend using a card. Generally, the stronger your credit history, and the larger and more secure your income, the bigger your credit line might be. Consumers with excellent credit scored (above 800) average spending limits right at $10,000 on their cards while those with scores under 600 will have $1,000 spending limits.

Cardholders can make purchases up to the credit line’s limit but must pay back the borrowed amount at the end of a monthly billing cycle or face interest charges. Borrowers are allowed to carry balances from month to month if they make minimum required payments, but the interest payments on the unpaid balances can be very costly.

Lenders call this revolving credit because, unlike a conventional bank loan with a pre-determined payoff date, payment on revolving credit it is open ended. Standard loans are made in lump sums and are closed when their balances are repaid. Revolving credit funds, by contrast, are available when you want to access them as long as you make minimum payments and don’t exceed the credit limit.

Credit cards are the most common form of revolving credit, but home equity lines of credit (HELOCs), retail and department store cards, and gas station cards all fall in this category.

Credit cards have spending limits and the cardholders are expected to repay some or all of the amount advanced at the end of the month. If the cardholder makes at least the minimum payment, the line of credit remains available, less the unpaid balance. If the cardholder does carry a balance forward, interest charges are added to the next bill, increasing the amount owed.

The same conditions apply to retail cards, which are credit cards offered through retail and department stores, warehouse stores, gas stations, online merchants and other vendors who hope to build a closer relationship with their customers.

Credit cards are unsecured debts, which means a lender can’t seize your property if you fail to repay them. But failing to make payments can seriously damage your credit, which could affect many aspects of your financial life.

Not all revolving credit is unsecured, though. HELOCs, or instance, use your home as collateral. HELOCs resemble credit cards in that consumers are extended a line of credit that can be renewed as it’s paid back. The credit limit on a HELOC is determined by the value of your home, which serves as collateral for the loan. The payback for HELOCs differs from credit cards in that HELOCs have a time limit — usually 5-10 years after the final disbursement – in which the loan must be paid back. HELOC interest rates are usually lower than a credit card.

HELOCs typically are used for home improvements, but they also help with debt consolidation and paying for college, though it is important to remember that HELOCs are mortgages and if you default on your debt, the lender can take your home through foreclosure.

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.

The bank charges interest on the unpaid balance when you do not pay off the balance in full every month. Typical interest rates can range from 10% to 29%, based on credit history and the lender. The average interest rate in the summer of 2018 was 16.2%.

While about 40% of cardholders pay their full balance each month, many Americans get caught in the revolving credit trap and are stuck paying a significant amount of interest over time.

Though credit cards are the most widely used forms of revolving credit, other forms that are secured with assets also use the revolving model.

Revolving credit is really a broad category that differs from installment loans in several ways:
  • Revolving credit is a credit line that allows you to borrow up to a maximum amount. As long as you make minimum monthly payments and stay below the maximum, you can keep borrowing and repaying for as long as the credit line permits.
  • Revolving credit can usually be used to pay a wide assortment of expenses. Installment loans, by contrast, are often issued as a lump sum to the borrower to pay for a specific thing, which might be applied as collateral against default. Installment loans generally have fixed repayment schedules and payoff dates. Installment loans can, among other things, be used to buy houses, pay for cars and finance educations.

How to Use Revolving Credit to Your Advantage

Revolving credit can be a boon to your lifestyle if used properly. Perhaps the biggest advantage is convenience and safety. If you go to a restaurant, supermarket or home improvement store, it is much easier to use an automated card reader to make payment than to bring cash or a checkbook. Credit cards are also safer than cash: If you lose cash, it’s gone. If you lose a credit card or it’s stolen, you can get a new one and not be liable for charges a thief might make using it. Though bank debt cards serve a similar function, you must be careful not to exceed the balance in your checking or savings account or an overdraft fee might be assessed.

Card perks are another plus. Many cards offer cash back on purchases, often ranging from 1% to 6% of your bill. Some offer frequent flier miles instead. And a number offer extended warranties, travel and rental car insurance and low-price guarantees.

Revolving credit allows you to use as much or as little of your credit limit as you want. When you pay back what you use, that full amount becomes available again. You don’t have to re-apply for revolving credit every month.

For example, if you have a credit card with a $1,000 credit limit and use it to buy $1,000 worth of appliances, you have used all your credit. If you make a $500 payment on the card, you regain $500 worth of credit for use on more purchases. If you pay the entire $1,000, you would have the full $1,000 credit limit back.

Revolving credit’s flexibility allows you to make purchases, like the appliances mentioned above, when you don’t have the cash available to purchase the product. Credit cards are accepted nearly everywhere you would shop.

Revolving credit is a great way to build a credit history. When you consistently repay the debts on revolving credit accounts, you demonstrate responsibility and creditworthiness. That is a huge factor in your credit score, which in turn, is a plus when you apply for mortgages, auto loans or personal loans.

People who don’t have a regular paycheck can benefit from revolving credit if they use it wisely. If you are a freelancer or contract worker whose income fluctuates constantly, revolving credit gives you a chance to pay bills and make purchasers during fallow periods, then catch up when your paycheck comes in. To avoid excessive finance charges, it’s important to pay off balances as soon as possible.

Though revolving credit has advantages, not using it correctly can lead to myriad financial problems.

Some “credit-card don’ts” you should pay attention to include:
  • Not paying your card in full, or nearly in full, every month. Running balances can make credit cards very expensive. If you’re not careful, the rising debt load that you incur using cards too freely can overwhelm your ability to pay and lead to defaults.
  • Keep balances low. Rating agencies that assign credit scores add up all your credit limits and compare you credit card balances to those limits. If your balances exceed 30% of your total credit limit, your credit score could be lowered.
  • Don’t apply for too many cards. Applying for a credit card requires a check of your credit, and credit checks can lower your credit score. Adding to you credit card collection from time to time is OK, especially if you find a card with perks that work well for you.

Disadvantages of Revolving Credit

Failing to pay back what you borrow each month results in interest charges that can cripple you financially.

However, revolving credit becomes a severe disadvantage when it’s misused. The temptation to make impulse purchases and worry about paying for them later looms and can lead to severe financial problems.

If you lack discipline and use a credit card to the spending limit, you will develop reckless habits. Failing to pay off the balance at the end of the month, subjects you to higher interest charges, some exceeding 29%, that will make your credit card debt overwhelming.

Using credit cards responsibly can help improve your credit score, but missed payments can put your accounts into default, damaging your credit score. A low score will almost certainly mean you’ll have to pay high interest rates when you need to borrow in the future, if you can get a loan or a credit line at all.

Revolving Credit Examples

Revolving credit offers access to funds up to a limit set when the credit line is opened. If the balance isn’t paid off at set intervals, usually monthly, interest is assessed on the unpaid balanced.

Credit cards and HELOCs are the most commonly used forms of revolving loans, but there are others, including:
  • Store credit cards
  • Gas station cards
  • Personal lines of credit
  • Business lines of credit
  • Margin investment accounts
  • Deposit accounts with overdraft protection

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 over time.
  • Line of Credit (or LOC) – An arrangement between a financial institution and a consumer that establishes a maximum loan amount and allows 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.
  • Revolvers: Borrowers who always maintain a balance on their credit cards from month to month by not paying them off completely. Revolvers pay what is essential, but always maintain a debt that accrues interest. They are the main source of income for credit card issuers.
  • Secured Loan -A loan that is backed by collateral (e.g. a car, house or piece of property).
  • Unsecured Loan – A loan not backed by collateral. Credit cards, student loans and medical bills fall into this category.

Difference Between Revolving Credit and a Loan?

There are major differences between revolving credit and loans.

Revolving credit can be used to make purchases on just about any goods or services. Traditional loans – including mortgages, auto loans, and student loans — have a specific purchasing purpose in mind. The consumer tells the lender what he’s using the loan for and can’t deviate from that.

Revolving credit is an open-ended credit line. There is not a set monthly payment, and the length of the credit is ongoing. You can make purchases on any item or service, as long as you don’t exceed your spending limit and make at least minimum payments every month.

A loan is a close-ended credit option. This means that the loan is a fixed amount and a set time period for payoff with specified monthly payment amounts.

Most lenders will want to know the specifics of how you intend to use the loan and could ask for collateral to secure the loan.

Another important difference is that when you pay off the loan amount, the loan is over. It does not automatically renew the way it does with revolving credit.

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, the more flexibility you have in choosing a credit line.

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 should be used cautiously. Consumers need to have knowledge of how a line of credit works and the risks associated with this type of financing.

Revolving Credit Statistics

The use of revolving credit — via credit cards and HELOCs — is surging in the United States, and that may not be such a good thing.

The Federal Reserve Board report says that revolving credit debt continues to increase steadily, rising from $908.4 billion at end of the first quarter in 2017 to $1,028.5 billion at the end of the same period in 2018.

Credit card debt defaults have decreased in the decade since the Great Recession, a function of higher employment rates in an improving economy. But consumers are using their cards to borrow more. The average American household debt was $5,700 in early 2018, but the average for households carrying credit card debt was $9,333. More than 41% of U.S. households carry some amount of credit card debt, but those with the lowest net worth – none to negative – had an average debt of $10,308.

Much of that is fueled by the fact that 5 million new credit cards were issued in 2015. According to the Federal Reserve, only 13.5% of credit card applications were rejected. That’s a huge drop from the 20% rejection level for credit cards that has been consistent since the Fed started the survey in 2013.

Bill Fay

Bill Fay is a journalism veteran with a nearly four-decade career in reporting and writing for daily newspapers, magazines and public officials. His focus at Debt.org is on frugal living, veterans' finances, retirement and tax advice. Bill can be reached at bfay@debt.org.

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