What is a Revolving Credit?
Revolving credit refers to a situation where credit replenishes up to the agreed upon threshold, known as the credit limit, as the customer pays off debt. It offers the customer access to money from a financial institution and allows the customer to use the funds when needed. It usually is used for operating purposes and the amount drawn can fluctuate each month depending on the customer's current cash flow needs.
- Revolving credit allows customers the flexibility to access money up to a predetermined limit, known as the credit limit.
- When the customer pays down an open balance on the revolving credit, that money is once again available for use.
- Revolving lines of credit may be secured by a company's assets, in which case the bank has the ability to seize property if the debts are not paid in a timely manner.
Revolving Line of Credit
Understanding Revolving Credit
The credit limit is the maximum amount of credit a financial institution is willing to extend to a customer seeking the funds. The credit limit is fixed when the financial institution, typically a bank, reaches an agreement with the customer. Financial institutions sometimes charge a commitment fee upon establishing a revolving line of credit. In addition, there are interest expenses on open balances for corporate borrowers and carry-forward charges for consumer accounts.
Financial institutions consider several factors about the borrower's ability to pay before revolving credit is issued. For an individual, the factors include credit score, current income, and employment stability. For an organization or company, a financial institution reviews the balance sheet, income statement, and cash flow statement.
A company may have their revolving line of credit secured by company-owned assets. In this case, the total credit extended to the customer may be capped at a certain percentage of the secured asset. For example, a company may have their credit limit set at 80% of their inventory balance. If the company defaults on their obligation to repay the debt, the financial institution can foreclose on the secured assets and sell them in order to pay off the debt.
Revolving credit is useful for individuals or entities that experience sharp fluctuations in cash flow or face unexpected expenses. Because of the convenience and flexibility, a higher interest rate typically is charged on revolving credit compared to traditional installment loans. Revolving credit typically comes with variable interest rates that may be adjusted.
Common examples of revolving credit include credit cards, home equity lines of credit, and personal lines of credit.
Revolving Credit vs. Installment Loan
Revolving credit differs from an installment loan, which requires a fixed number of payments over a set period of time. Revolving funds require only the minimum payment of interest plus any applicable fees. Revolving credit is a good indicator of credit risk and has the potential to impact an individual's credit score considerably depending on usage. Installment loans, on the other hand, can be viewed more favorably on an individual's credit report, assuming all payments are made on time.
Revolving credit implies that a business or individual is pre-approved for a loan. A new loan application and credit reevaluation does not need to be completed upon each instance of utilizing the revolving credit. Revolving credit is intended for shorter-term and smaller loans. For larger loans, financial institutions require more structure, including installation payments.
However, it should be noted that a revolving credit agreement will often include a clause that allows the lender to close down, or significantly reduce, a line of credit for a variety of reason's, not the least of which could be a severe economic downturn. It is important to understand what rights the lender has in this regard, per the agreement.
Revolving Lines of Credit vs. Credit Cards
Credit cards are the best-known type of revolving credit, which involves the ability to carry a balance over time that accrues interest. However, there are numerous differences between a revolving line of credit and a consumer or business credit card. First, there is no physical card involved in using a line of credit as in the case of a credit card, as lines of credit are typically accessed via checks issued by the lender. Second, a line of credit does not require a purchase to be made. It allows money to be transferred into a customer's bank account for any reason without requiring an actual transaction using that money.
This makes a revolving line of credit similar to a cash advance as funds are available upfront. Lines of credit also typically have lower interest rates compared to credit cards. Revolving lines of credit can be fully funded, or not funded.