Revolving 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.
The lending institution (or card company) puts a cap on the loan amount — referred to as a credit limit — and allows the consumer to spend that amount on an as-needed basis. At the end of a billing cycle (usually one month), the consumer is expected to repay the full amount of credit used, or at least make a “minimum payment.”
Consumers can carry a balance forward and keep the loan going. That is the “revolving” part. Unlike a standard loan that ends when the balance is paid off, revolving credit automatically renews as long as you make minimum payments, and don’t exceed the credit limit.
Credit cards have a spending limit and the cardholder is expected to repay some or all the amount used at the end of the month. As long as the cardholder makes at least the minimum payment, the line of credit remains available. If the cardholder does carry a balance forward, interest charges are added to the next bill.
The same conditions apply to retail cards.
HELOCs are similar to 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 is usually lower than a credit card.
HELOCs typically are used for home improvements, but they also help with debt consolidation and paying for college.
Debt Stats for Revolving Credit
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 increased for 9 straight months in 2015. By the end of the year, revolving debt reached $923.6 billion, which is a 7.5% increase for the year.
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.
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.
- 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.
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. While about 40% of cardholders pay their full balance 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.
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.
Advantages vs. Disadvantages of Revolving Credit
The major advantage of revolving credit is that it is flexible and convenient. The major disadvantage is that failure to pay back what you borrow each month results in interest charges that can cripple you financially.
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 purchase price immediately available, either in cash or checking accounts. Credit cards are accepted nearly everywhere you would shop.
Revolving credit also 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 huge factor when you apply for mortgages, auto loans or personal loans.
However, revolving credit becomes a severe disadvantage when it’s misused. The temptation to make impulse purchases and worry about paying for it later is always there and can become the source of financial problems.
If you use don’t have 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 interest charges, some as high as 29%, that will make your credit card debt overwhelming.
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.