When it comes to credit, there are two major types you should know about: revolving and non-revolving. 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.
Payments are made, usually, one 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 (e.g. 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 a $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.
Non-Revolving Credit Defined
Non-revolving 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.
Non-revolving credit products often have a lower interest rate compared to revolving credit. This stems from the lower risk associated with non-revolving 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 non-revolving 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 deny.
Revolving vs. Non-Revolving Credit
While non-revolving 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, non-revolving 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 non-revolving credit product, carefully consider the terms and borrowing cost and stick to the repayment agreement so you don't hurt your credit.