Your credit score is an important component of your financial health, although you may not realize it until you’re ready to apply for a credit card, finance a car or purchase your first home. Good or excellent credit makes it easier to qualify for the financing you need with the best rate terms, whereas bad credit does the opposite. With poor credit, you may not qualify for any financing at all, and if you do, you could wind up paying higher fees and considerably more interest over time.
With that in mind, it’s important to understand how moves you make can impact your credit score over time. Revolving credit is typically a good addition to your credit report and profile, but you’ll want to use revolving credit accounts responsibly for maximum results.
What is revolving credit?
Revolving credit works differently than other types of loans because a revolving line of credit is one you can borrow against over and over. Where a personal loan gives you a lump sum of money that you pay off over time via fixed monthly payments, revolving credit is a line of credit that lets you use only what you need. As a result, your monthly payments on a revolving line of credit may go up and down depending on how high your balance is.
How does revolving credit work?
The best example of revolving credit is a typical credit card. With a credit card, you qualify for a line of credit with a specific limit, and you can charge purchases up to the card’s limit. You’re only charged interest on the balances you carry from month to month, however. Any balances you carry can also be referred to as a “revolving balance.”
Here’s a more specific example: Imagine you just signed up for a credit card and got approval for a $10,000 credit limit right away. You charge a few dinners and some groceries to your credit card and wind up with a $450 balance on your credit card statement that month.
If you don’t have $450 to pay your credit card bill in full, you could make at least the minimum payment on your credit card and carry a revolving balance to the following month. Once you made your minimum payment for the month, you would be charged interest on the remaining balance (revolving balance).
Do I need revolving credit?
There are numerous benefits that come with having a line of credit you can use when you need it, such as a credit card. The most important benefits include:
- Having a line of credit available if you have an emergency or surprise expense to take care of
- Adding depth to your credit profile
- Helping you learn positive credit habits
Like any other type of credit, revolving credit can work for you or against you. If you use revolving credit to borrow money responsibly and you keep up with your payments, then revolving credit can help you in more than one way. If you feel you might use revolving credit to begin a debt-fueled lifestyle that could easily spiral out of control, on the other hand, you should avoid credit cards and other lines of credit that might tempt you.
How does revolving credit affect my credit score?
Revolving credit has the potential to impact your credit score in a few different ways, but the most important area it affects is how much you borrow in relation to your credit limits. This factor, which is also known as credit utilization, makes up 30% of your FICO score. Generally speaking, you will position yourself for better credit if you keep your total credit utilization across all your credit card accounts below 30%, meaning you make sure you owe $3,000 or less for every $10,000 in credit available to you.
With a credit card or another revolving line of credit, maintaining a reasonable level of credit utilization can be tricky. After all, credit cards are so convenient to use that they often leave consumers with more debt than they realized.
Further, you can actually hurt your credit score if your credit utilization rate remains high, and particularly if you’re constantly maxing out your credit cards and other lines of credit that are available to you.
Can revolving credit accounts raise my credit score?
If you have limited credit history and you need a way to prove your creditworthiness, then a revolving account like a credit card can absolutely help boost your credit score. You could apply for a secured credit card or another credit card geared to building credit, then use your card for small purchases you could pay off right away.
From there, your credit card issuer will report your credit card usage and history to the three credit bureaus. Keep in mind, however, that your payment history is the most important factor that makes up your FICO score at 35%, so you’ll want to be sure you pay your credit card bill (and all other bills) early or on time each month.
Will opening a revolving line of credit improve my credit score?
If you don’t have a revolving line of credit, opening one has the potential to boost your credit score in another category. Your “credit mix” is another factor that makes up 10% of your FICO score, and this is determined by the types of credit you have available to you.
While it’s not necessarily important to have every type of credit available on the market according to myFICO.com, your credit mix will benefit if you have more than one. This means that, if you only have an auto loan or a mortgage on your credit report, adding a revolving line of credit like a credit card could potentially improve your credit over time.
How can you get a revolving credit account?
You can add a revolving line of credit to your credit profile by researching all your options and applying for one. Keep in mind that not all lines of credit work for every borrower, and that you should research all options thoroughly before you decide. If you opt for a credit card, for example, you shouldn’t sign up for the first credit card you come across. Instead, you should research credit cards in terms of the rewards they offer, their interest rates and other factors.
Either way, there are numerous revolving lines of credit you can apply for online, which can make the process easier and more stress-free.
What counts as revolving credit?
Credit cards are the most popular type of revolving credit, but you should note that a Home Equity Line of Credit (HELOC) is similar to a credit card during what is known as a “draw period.” This is due to the fact this loan product extends a line of credit you can borrow against and repay as needed. You can also carry a revolving balance with a HELOC, or choose to pay your balance each time you borrow.
A personal line of credit can also be considered revolving credit for the same reasons. You can borrow what you need and pay it back right away, but you can also carry a revolving balance if you need to.
How is interest calculated on a revolving line of credit?
If you’re curious how much interest you’ll pay on a revolving line of credit, you should know that you won’t pay any interest if you pay your balance in full by the statement due date. Interest is only charged on revolving balances you carry from the previous month.
Most lines of credit also use the simple interest method, meaning you’ll never pay interest on interest charges. Instead, you’ll only pay interest on your actual charges.
Most lines of credit, including credit cards, use the average daily balance method to determine how much interest you pay. This method requires them to determine your average daily balance by adding each day’s balance and dividing it by the number of days in the month. From there, that number is multiplied by one-twelfth of your annual percentage rate to determine your monthly interest charges.
Note that credit cards come with a grace period that allows you to pay your balance in full and avoid interest charges, and the average daily balance method is only used for people who carry a revolving balance from one month to the next.