Revolving credit is a credit line you can borrow against and repay over and over again. It can be a flexible way to borrow, but it's not ideal for every purchase. Learn how revolving credit works and whether it's a good choice for your financial plans.
What Is Revolving Credit?
Revolving credit means you're borrowing against a line of credit. Let's say a lender extends a certain amount of credit to you, against which you can borrow repeatedly. The amount of credit you're allowed to use each month is your credit line, or credit limit. You're free to use as much or as little of that credit line as you wish on any purchase you could make with cash.
At the end of each statement period, you receive a bill for the balance. If you don't pay it off in full, you carry the balance, or revolve it, over to the next month and pay interest on any remaining balance. As you pay down the balance, more of your credit line becomes available.
"A classic example of revolving credit is a credit card," explains G. Brian Davis, personal finance columnist and co-founder of Spark Rental, an educational site for real estate investors. "The balance goes up and down as the consumer either pays it down or charges it up. The monthly payment fluctuates alongside the balance."
That's different from when you need to borrow money for a specific purpose -- to buy a car or to cover college tuition, for example. For that, you'd typically take out an installment loan, essentially borrowing one big chunk of money and paying it off in monthly installments until the debt is gone.
[Read: Best Student Credit Cards.]
Consider the difference between a home equity line of credit and a home equity loan. "A HELOC is a revolving line of credit that homeowners can draw on or pay down," says Davis. But a lump sum home equity loan has a fixed loan amount and repayment term. "It's a classic installment loan," he says.
Revolving credit is best when you want the flexibility to spend on credit month over month, without a specific purpose established up front. It can be beneficial to spend on credit cards to earn rewards points and cash back -- as long as you pay off the balance on time every month.
How Does Revolving Credit Affect Your Credit Score?
Any time you spend on credit, it can have an impact on your FICO credit score, the score most commonly used by lenders. How you handle that credit will determine whether the impact is positive or negative.
Credit bureaus consider several factors when calculating your FICO credit score. The biggest, accounting for 35% of your score, is your payment history.
Missing payments on credit cards or other revolving credit accounts can have a dramatic and lasting impact on your score. But if you consistently make your payments by the due date, you will build a positive payment history that strengthens your score over time.
The second-most-important factor in determining your FICO score is the amounts owed, which accounts for 30% of your score. Relying too heavily on the credit extended to you is a major red flag to lenders, since it might appear you don't have enough money to keep up with expenses. The last thing you want to do is max out your credit lines.
[Read: Best Starter Credit Cards.]
To find your credit utilization ratio, a measure of how much credit you're using, divide your total outstanding balances by the total amount of credit extended to you.
"By keeping your balances low compared to the credit lines you have, that will boost your credit score," says Lee Huffman, credit card expert at Bald Thoughts, a travel rewards resource. "Banks become concerned if you max out your credit limits because that could be a sign of financial distress."
You should keep your credit utilization ratio under 30%. That means if you have a total credit limit of $3,000, you should keep your outstanding debt on your cards under about $1,000 to be safe.
Your credit utilization can be high even if you pay off your balance every month, however. That's because your balance is often reported to the credit bureaus the day your statement closes, which is different from your due date when you might pay it off. For that reason, it's best to avoid running up a large balance, even if you plan to pay it off in a couple of weeks.
Credit History and New Credit
Creditors like to see a long, steady history of using credit responsibly, which is why your credit history makes up 15% of your FICO score. The older your credit accounts, including credit cards and other types of revolving credit, the better.
At the same time, too many accounts opened within a short period of time will not only lower the average age of your credit but will signal to lenders that you could be desperate for more credit. That's why new credit makes up 10% of your FICO score.
If you apply for revolving credit and are denied, consider factors that led to the denial and work on improving them before applying again. Or, look for a product you're more likely to be approved for.
The final 10% of your credit score is based on your credit mix. Lenders like to see that you have experience managing different types of debt, including a good mix of installment loans and revolving credit.
[Read: Best No-Annual-Fee Credit Cards.]
So, if you have limited experience with credit -- maybe you only have student loans from your early adult years -- it could be beneficial to diversify with a revolving credit account, such as a credit card.
Is Revolving Credit Good?
Revolving credit can help you manage expenses before your next paycheck arrives. Plus, using rewards credit cards on purchases you have to make anyway is a great way to put money back in your pocket. Just make sure you're doing it right.
-- Keep balances low. With a credit card or other types of credit, you're able to use up to 100% of the credit extended to you. But that doesn't mean you should. Maxing out your credit line will lower your credit score. "You can boost your credit score by lowering your credit utilization in a couple of different ways," Huffman says. "Paying down your balances is always a good idea." If you can't pay off your balance, another option is to increase your credit limit. However, the key is not to add more debt to your new, higher limit.
-- Pay on time every month. The average maximum credit card late payment fee is about $36, according to the U.S. News research. Plus, some issuers will raise your annual percentage rate on future purchases as a penalty. A penalty rate may apply for payments at least 60 days late, and a late payment could trigger a potentially severe drop in your credit score. Staying on top of your bills is the most impactful thing you can do to maintain good credit.
-- Avoid too many applications for revolving credit. Before applying for a credit card or other type of credit, be sure your credit score is in good shape to avoid being rejected. And if you are approved, space out future applications to avoid a ding to your credit score.
Revolving credit can have a positive or negative effect on your credit score, depending how you use it. If you're a responsible spender and pay your bills on time, you should be able to use credit to your advantage while building a good credit score.
Casey Bond is a seasoned personal finance writer and editor. Her work has appeared in a number of major national publications including U.S. News & World Report, Yahoo Finance, MSN, The Huffington Post, Business Insider, Forbes and others. Follow her on Twitter @CaseyLynnBond.