What Is Revolving Credit?
Revolving credit is an agreement that permits an account holder to borrow money repeatedly up to a set dollar limit while repaying a portion of the current balance due in regular payments. Each payment, minus the interest and fees charged, replenishes the amount available to the account holder.
Credit cards and lines of credit both work on the principle of revolving credit.
- Revolving credit allows customers the flexibility to access money up to a preset amount, 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, minus the interest charges and any fees.
- The customer pays interest monthly on the current balance owed.
- Revolving lines of credit can be secured or unsecured.
How Does a Revolving Line of Credit Work?
When a borrower is approved for revolving credit, the bank or financial institution establishes a set credit limit that can be used over and over again, all or in part. A credit limit is the maximum amount of money a financial institution is willing to extend to a customer seeking the funds.
Revolving credit is generally approved with no date of expiration. The bank will allow the agreement to continue as long as the account remains in good standing. Over time, the bank may raise the credit limit to encourage its most dependable customers to spend more.
Borrowers pay interest monthly on the current balance owed. Because of the convenience and flexibility of revolving credit, a higher interest rate typically is charged on it compared to traditional installment loans. Revolving credit can come with variable interest rates that may be adjusted. The costs of revolving credit vary widely:
- A home equity line of credit (HELOC) could be obtained with an interest rate under 5% by customers with excellent credit ratings as of May 2021. This type of credit is essentially a second mortgage, with the account holder's home serving as collateral.
- At the other end of the scale, credit cards come with an average interest rate of almost 15% for customers with excellent credit ratings, and it's close to 18% for "starter cards" for young consumers. And that doesn't factor in any fees attached to the account.
Lenders consider several factors about a borrower's ability to pay before setting a credit limit. For an individual, the factors include credit score, current income, and employment stability. For an organization or company, the bank reviews the balance sheet, income statement, and cash flow statement.
Revolving Credit Examples
Common examples of revolving credit include credit cards, home equity lines of credit (HELOCs), and personal and business lines of credit. Credit cards are the best-known type of revolving credit. 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 there is with a credit card; lines of credit are typically accessed via checks issued by the lender.
Second, a line of credit does not require the customer to make a purchase. It allows money to be transferred into a customer's bank account for any reason without requiring an actual transaction using that money. This is similar to a cash advance on a credit card but does not typically come with the high fees and higher interest charges that a cash advance can trigger.
Revolving Line of Credit
Types of Revolving Credit
Revolving credit can be secured or unsecured. There are major differences between the two. A secured line of credit is guaranteed by collateral, such as a home in the case of a HELOC. Unsecured revolving credit is not guaranteed by collateral, or an asset—for example, a credit card (unless it is a secured credit card, which does require the consumer to make a cash deposit as collateral.)
A company may have its 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 financial institution may set a credit limit at 80% of a company's inventory balance. If the company defaults on its obligation to repay the debt, the financial institution can foreclose on the secured assets and sell them in order to pay off the debt.
Because unsecured credit is riskier for lenders, it always comes with higher interest rates.
Advantages and Disadvantages of Revolving Credit
The main advantage of revolving credit is that it allows borrowers the flexibility to access money when they need it. Many businesses small and large depend on revolving credit to keep their access to cash steady through seasonal fluctuations in their costs and sales.
As with consumers, rates for business lines of credit vary widely depending on the credit history of the business and whether the line of credit is secured with collateral. And like consumers, businesses are able to keep their borrowing costs minimal by paying down their balances to zero every month.
Revolving credit can be a risky way to borrow if not managed prudently. A significant part of your credit score (30%) is your credit utilization rate. A high credit utilization rate can have a negative impact on your credit score. Most credit experts recommend keeping this rate at 30% or below.
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 reasons, including a severe economic downturn. It is important to understand what rights the lender has in this regard, per the agreement.
Revolving Credit vs. Installment Loan
Revolving credit differs from an installment loan, which requires a fixed number of payments including interest over a set period of time. Revolving credit requires only a minimum payment plus any fees and interest charges, with the minimum payment based on the current balance.
Revolving credit is a good indicator of credit risk and has the potential to impact an individual's credit score considerably. 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 do not need to be completed for each instance of using the revolving credit.
Also, revolving credit is intended for shorter-term and smaller loans. For larger loans, financial institutions require more structure, including installment payments in preset amounts.