You might be using revolving credit every day. Think: credit cards and lines of credit.
But as convenient as revolving credit is, it can be risky if you are not careful. Read on to learn about how revolving credit works, its benefits, how much you should have, and its connection to your credit score.
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How does revolving credit work?
Simply put, revolving credit is credit that you can use, pay back down, and then use again. Hence why it’s called revolving. If your credit application is approved, your lender gives you access to borrow up to a certain credit limit on different credit products such as a credit card or line of credit. It is credit that is continuously available to you as long as your bank does not cancel your card or credit line. This differs from credit like a car loan which you pay down and once paid off you no longer have access to borrow any more funds without reapplying for new credit.
Revolving credit doesn’t become debt until you borrow from it. For example, you may have a credit card with a $2,000 limit. If you don’t use it to pay for anything, then your balance remains $0 and you have no debt. But let’s say you used your credit card to buy something for $200, you would then owe $200 on your credit card by the payment due date.
The cost of using revolving credit varies by the credit type. For example, credit cards give you a no-interest grace period. If you pay your credit card balance in full by the due date, you won’t get charged interest on what you borrowed. A line of credit, on the other hand, typically charges interest from the day you borrow until you pay the balance back in full.
Types of revolving credit
There are three types of revolving credit accounts: credit cards, unsecured lines of credit, and secured lines of credit like a home equity line of credit (HELOC).
Credit cards
There are two types of credit cards: secured and unsecured. They are both revolving credit accounts.
Secured credit cards are special because they require an upfront deposit. One of the main advantages of a secured credit card is to help individuals with low credit rebuild a healthier payment history. With a secured credit card, your cash deposit becomes your credit limit. For example, if you put in $500 on deposit with your secured card provider, you will have a $500 limit on the card. Your deposit becomes the lender’s insurance in case you start defaulting on payments. Note that with a secured card, any purchases you make will still need to be repaid because your deposit on the card is not the money you are spending. It’s the lender’s collateral. So, if you buy something for $20 on a secured credit card, you will still need to repay that $20 by the payment due date. Interest rates on secured cards typically range from 19% to 25%. Aside from the deposit component, you can use a secured credit card just like a regular, unsecured credit card. By making full and timely payments, you can build a better credit score over time.
Unsecured credit cards don’t require a deposit and have limits that can range from $1,000 to $10,000+. Your bank will assess your credit health and determine the credit limit they will let you have on an unsecured card. Low interest cards are available for those with prime credit, but most regular unsecured credit cards typically carry interest rates of 19% to 29%. They may also come with annual fees. Some credit cards may also offer you rewards like air miles or cashback on purchases you make.
Unsecured lines of credit
An unsecured or personal line of credit is a revolving line of credit with a set limit. Again, your bank will approve your credit limit based on your creditworthiness. Interest rates on unsecured lines of credit can range from 6% to 14% from a main bank or credit union. Lines of credit often charge a variable interest rate, meaning it could change at the lender’s discretion.
When you borrow from a line of credit, the interest charges start right away, and you will be charged on the money you borrow until you pay your balance in full. There is no grace-period like with a credit card.
There are also personal lines of credit offered by rapid loan lenders, charging interest rates of 45% or higher. These lines of credit are targeted at individuals with low credit who otherwise won’t qualify at a bank. We caution against borrowing loans or lines of credit from these high-cost lenders because it can lead to serious debt problems. Repaying your balances in full becomes an impossible task because of the higher interest rates and added fees these lenders charge.
Secured line of credit
The most common example of a secured line of credit is a home equity line of credit (HELOC), which is secured against the equity in your home. Lenders allow you to borrow up to 80% of your home’s value as a revolving credit line. HELOCs generally have variable interest rates based on the lender’s prime rate.
Like unsecured lines of credit, interest charges start on anything you borrow on a HELOC from the first day until you pay off your balance in full. The biggest risk with borrowing from a HELOC is that it is secured against your home. You may risk losing your home if you borrow more than you can repay.
HELOCs are also a callable debt, which means your lender can change the rules and conditions whenever they want to. For example, your lender may require you to repay your whole balance at once. This can be a shock to your finances and a risk to your home if you are not ready.
What is non-revolving credit?
Non-revolving credit is a product that you cannot continuously borrow from and repay. Non-revolving credit is also known as an installment loan. For example, a student loan, personal loan, auto loan, or a mortgage are all non-revolving credit products. These loans typically have set monthly payments. Once you pay off non-revolving credit, you no longer carry that debt.
How much revolving credit should you have?
One of the most common questions people ask is how much revolving credit they should have access to. From our experience, you should only have access to the amount of credit you could comfortably repay in full if you were to ever borrow the maximum amount. You may from time to time receive an offer for a pre-approved credit limit increase but while these are tempting, we recommend only having access to the available credit you actually need. This is to prevent getting into too much debt and risking your financial health.
There is also a relationship between how you use revolving credit and your credit score. Credit utilization is the second largest item in your credit score calculation. Your credit utilization ratio is the percentage of total credit you borrow from the total credit room you have available (including all lines of credit and credit cards). It is recommended that you use only 30% of your total available credit room every month to maintain a healthy credit score and to show your lender that you can manage credit responsibly. If you are regularly reaching the maximum limit, this will have a negative impact on your credit score. Carrying too much debt can also lower your chances of qualifying for a loan at a good interest rate or having your loan application rejected by your bank altogether.
What are the benefits and risks to revolving credit?
The key benefits to revolving credit include access to credit whenever you need it, and the ability to build and maintain a positive credit history to qualify for lower interest rates on personal loans or a mortgage.
The main risk to revolving credit is taking on more debt than you can repay. Luckily, you can avoid debt problems by always repaying what you borrow in full every month. You should also avoid making only the minimum payments on credit cards or lines of credit because that will keep you indebted forever.
Summary
It’s important to understand how revolving credit products work because they are some of the most common and important tools we use to manage our personal finances. When used responsibly, they can allow us to build a strong credit report to qualify for other important loans like a car loan or mortgage. Unfortunately, revolving credit can also get out of hand quickly leading to debt problems.
If you feel you owe too much on your credit cards or lines of credit and you’re struggling to repay your balances or only making the minimum payments, don’t hesitate to contact us for a free consultation to review your situation and discuss relief options.
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