Debt Consolidation

What Is Revolving Debt

While all debt is — in the simplest definition — money owed to a lender, that’s not the end of the story. There are different types of debt and they work and affect you in different ways. For example, a credit card is a revolving debt and affects your credit report differently than an installment debt, such as a personal loan.

Knowing the type of debt you’re taking on can empower your borrowing decisions because you’ll have a better understanding of how the particular debt may affect your repayment schedule, flexibility in borrowing and your credit report.

In this article, we explain what revolving debts are, how they work and how revolving debt can affect your credit score.

What is a revolving credit account?

Revolving credit is one of the most common types of debt you’ll run into as a borrower.

Revolving credit is commonly referred to as a line of credit[1]. With revolving accounts, like a credit card or a personal line of credit, you can borrow against a credit line whenever you chose, up to a lender-established limit. You can borrow, repay the balance and borrow again without applying for new credit.

Lenders require you pay back only the money borrowed from your total limit on a revolving credit line, with interest.

Revolving credit lines generally charge a variable interest rate. The amount you are required to pay depends on how much credit you use and the interest charged during the statement period. Some revolving accounts, such as credit cards, have a grace period. If you make a payment during the grace period, you may not be required to pay interest on the amount you repaid.

Because revolving credit lines offer the borrower a lot of flexibility, the repayment period on a revolving line can vary greatly. It depends heavily on how much credit you use, the amount of interest you incur and how much over the minimum payment you make each month.

How revolving debt affects your credit score

Revolving debt most affects two factors in credit score: your credit mix and your credit utilization.

Having revolving accounts on your credit report adds to your credit mix, which comprises 10% of your FICO credit score and contributes to 20% of your VantageScore[2].

Your credit mix reflects how varied your experience with credit has been. A healthy mix of credit cards, retail accounts, installment loans, mortgages and other loans on your credit report demonstrates to lenders you are an experienced borrower. Having different kinds of revolving accounts in addition to installment accounts boosts your credit mix and contributes positively to your credit score.

The amounts owed on all of your credit accounts is the second-largest contributing factor to the two most popular credit scoring models. It determines 30% of your FICO credit score and 20% of your VantageScore. Using up a high percentage of your available credit communicates to lenders that your budget may be stretched. Thus, you may be more likely to make late or missed payments.

Your credit utilization ratio reflects how much of the total amount of revolving credit available to you that you’ve used up.  The percentage you’re using up on your revolving credit lines is more heavily factored into the “amounts used” calculation than what you have left to pay on your installment debts.

A high utilization ratio can negatively impact your credit score. However, a low utilization ratio may positively impact your score. For example, the closer you are to maxing out your credit cards and other revolving lines of credit, the lower your credit score. For a positive effect, experts recommend maintaining a utilization ratio below 30% of your total credit limit on revolving accounts.

2 other forms of credit: Installment credit and open credit

Installment credit is another common type of credit account. An installment loan, such as a personal loan, auto loan or mortgage, is paid out to you all at once so you can use the funds right away.

Installment debt is typically repaid in equal installments over a specified term. Depending on the lender’s terms, the interest rate on the installment account may be fixed or variable, although most of the time the rate is fixed. The rate may change on an adjustable-rate mortgage, for example.

Because many of the variables associated with an installment debt are fixed, the payments made and the repayment term on installment credit accounts are usually more predictable than with revolving accounts.

A third type of credit called open credit is so rare it really only deserves an honorable mention. With open credit accounts like a charge card, you can use it up to a limit for a specific period of time. When that period ends, the account must be repaid all at once.

Conclusion

Now that you understand what a revolving credit account is and its impact on your credit score, you are better equipped to make the best borrowing decisions for your financial situation.

If you need to borrow to purchase a new laptop, for example, you now know that it would be smarter to take out an installment loan, like a personal loan, and pay it back over time instead of opening, maxing out and carrying a balance on a revolving line of credit, like a credit card. The reason being carrying a revolving debt would negatively impact your credit score.

You can find more expert tips on how to make credit decisions that positively impact your credit score here.

 
 

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