When it comes to credit, there are two major types you should know about: revolving and nonrevolving. Understanding the differences is key to knowing which type to use in various financing situations and how each affects your credit long-term.
What Is Revolving Credit?
Revolving credit is a type of credit that can be used repeatedly up to a certain limit as long as the account is open and payments are made on time. With revolving credit, the amount of available credit, the balance, and the minimum payment can go up and down depending on the purchases and payments made to the account. Revolving lines of credit are sometimes known as "evergreen loans," and sometimes they have a cleanup requirement where borrowers are asked to pay down the balance to $0 for a period of time.
Usually, though, payments are made once each month, based on the current outstanding balance. Depending on the amount of time it takes you to repay what you've borrowed, an interest charge may be added to the balance periodically until the balance has been completely repaid.
You're probably already familiar with two common types of revolving credit: credit cards and lines of credit.
With revolving credit, you have the choice of repaying the balance over a period of time or immediately. If you choose to pay your balance over time, you only have to pay the monthly minimum payment required by the credit card issuer.
How Revolving Credit Works
You may get a credit card with ACME Bank with a $1,000 credit limit and the ability to make purchases on the card at any time as long as you stick to the terms (i.e. don't go over the limit and pay at least the minimum payment on time each month).
Let's say in the first month, you make $100 in purchases. You would have $900 of available credit left for other purchases. You can either pay your entire balance of $100, you can make the minimum payment specified on your billing statement, or you can pay an amount in between the minimum payment and your full balance. Let's say you choose to make the minimum payment of $25 and your balance goes down to $75 and your available credit goes up to $925.
You start month two with $75 and $925 of available credit. You're charged $10 in finance charges because you didn't pay your balance in full last month. You make another $100 in purchases, bringing your balance to $185 (the previous balance + interest + your new payments) and your available credit is $815. Again, you have the choice of paying the balance in full or making the minimum payment. You choose to pay in full this time. You pay the entire balance of $185, bringing your balance to $0 and your available credit back to $1,000 to start month three.
Charge cards deviate slightly from the definition of revolving credit. While you can use your available credit repeatedly, you cannot revolve the balance over several months without facing penalties. Charge cards require you to pay the balance in full each month.
Nonrevolving Credit Defined
Nonrevolving credit is different from revolving credit in one major way. It can't be used again after it's paid off. Examples are student loans and auto loans that can't be used again once they've been repaid.
When you initially borrow the money, you agree to an interest rate and a fixed repayment schedule, usually with monthly payments. Depending on your loan agreement, there may be a penalty for paying off your balance ahead of schedule.
Nonrevolving credit products often have a lower interest rate compared to revolving credit. This stems from the lower risk associated with nonrevolving credit products, which are often tied to collateral that the lender can seize if you default on payments. For example, your mortgage is tied to real estate that the lender can foreclose if you fall behind on your loan payments.
Once you pay off a nonrevolving credit account, the account is closed and can't be used again. You'll have to make another application and go through the approval process to borrow additional funds. There's no guarantee you'll be approved for the same terms and if your credit or financial situation has changed you could be denied.
Revolving vs. Nonrevolving Credit
While nonrevolving credit often has a lower interest rate and predictable payment schedule, it doesn't have the flexibility of revolving credit. You can use revolving credit for a variety of purchases as long as you stick to the credit card terms.
On the other hand, nonrevolving credit has more purchasing power because you can be approved for higher amounts, depending on your income, credit history, and other factors. Because of the risk involved, banks often limit the amount you can borrow on revolving credit. For example, you may not be able to purchase a house with a credit card without having a credit limit high enough to cover the cost.
Both types of credit accounts are useful in different situations. Make sure you choose the option that's best for the purchase you're making. Whether you're choosing a revolving or nonrevolving credit product, carefully consider the terms and borrowing cost and stick to the repayment agreement so you don't hurt your credit.
Frequently Asked Questions (FAQs)
What's a good percentage of revolving credit usage?
Credit utilization, which is the percentage of your revolving credit that you're using in a given month, is one of the most important factors affecting your credit rating. A utilization rate below 30% is considered good, and the lower you keep it, the more it will positively impact your score. That means if you have $10,000 in revolving credit, you should keep your statement balance total below $3,000 per month.
When is it best to use revolving credit?
Revolving credit is generally best suited for getting access to small amounts of cash for consumer purchases, home renovations, or repairs. It's designed to be accessed and paid down on a revolving basis, so you won't be able to use it for major purchases like a home or auto loan—and it would be much more expensive to do so. You'll want to have both revolving and nonrevolving credit on your record to improve your credit score, but revolving credit generally has a bigger impact on your rating.
What is the maturity date on a revolving line of credit?
The maturity date on a revolving credit line is the date at which all remaining interest and principal is due. Revolving lines that have this feature will usually have an initial period where you only have to pay interest, followed by the maturity date where you'll need to pay back the loan in full.