How Does Revolving Credit Function?
Revolving credit operates on a simple cycle of borrowing and repayment. A lender, such as a bank or credit union, approves you for a specific credit limit, which is the maximum amount of money you can borrow.
Unlike a traditional loan, you don’t receive the funds in a lump sum. Instead, you can draw from the account as needed. Each month, you receive a statement detailing your balance, transactions, and the minimum required payment. As you pay back the borrowed amount, your available credit is replenished and can be used again. Interest is charged only on the outstanding balance you carry from one month to the next.
Common Examples of Revolving Credit
You likely encounter and use revolving credit in your daily life. The most common forms include:
- Credit Cards: The most ubiquitous example. They allow you to make purchases up to a set limit and carry a balance month-to-month.
- Home Equity Lines of Credit (HELOCs): A line of credit secured by the equity in your home. Homeowners often use HELOCs for major expenses like renovations or consolidating debt, drawing funds as needed during a set “draw period.”
- Personal Lines of Credit: Offered by banks and credit unions, these are unsecured lines of credit that function like a credit card but without a physical card.
How Revolving Credit Impacts Your Credit Score
Managing revolving credit responsibly is essential for building a strong credit score. Lenders and credit bureaus pay close attention to two key factors:
- Credit Utilization Ratio: This ratio measures how much of your available credit you are using. To calculate it, divide your total revolving credit balances by your total credit limits. According to the Consumer Financial Protection Bureau, keeping this ratio below 30% is recommended for a healthy credit score.
- Payment History: Consistently making at least the minimum payment on time is one of the most significant factors in your credit score. Late payments can negatively impact your score and remain on your credit report for up to seven years.
Revolving Credit vs. Installment Credit
The two primary types of credit available to consumers are revolving and installment credit. Understanding their key differences is crucial for making informed financial decisions.
| Feature | Revolving Credit | Installment Credit |
|---|---|---|
| Repayment Structure | Flexible monthly payments with a required minimum. | Fixed, equal payments over a predetermined term. |
| Fund Access | Credit is reusable as the balance is paid down. | A single lump sum is provided upfront; the account is closed once repaid. |
| Common Examples | Credit cards, HELOCs, personal lines of credit. | Mortgages, auto loans, personal loans, student loans. (Installment Loan) |
Frequently Asked Questions (FAQs)
Is revolving credit good or bad?
Revolving credit is a financial tool; its impact depends on how it’s used. When managed well—by paying balances in full each month and keeping utilization low—it’s an excellent way to build credit and handle expenses. However, if you carry high balances and make only minimum payments, it can lead to a cycle of expensive debt.
Should I only make the minimum payment?
While making the minimum payment keeps your account in good standing, it’s a costly strategy. Only paying the minimum means your balance will decrease very slowly, causing you to pay significantly more in interest over time. The best practice is to pay the full statement balance whenever possible.
Does closing an old credit card improve my credit score?
Not necessarily. Closing a credit card, especially an older one, can hurt your credit score in two ways. First, it reduces your total available credit, which can increase your credit utilization ratio. Second, it can shorten the average age of your credit history, which is another factor in determining your score.