What Is Revolving Debt? Everything You Need To Know
Revolving debt is one of the most common loan types out there, but it’s best to be clued in to how it works before deciding to borrow.
May 13, 2022
Debt is debt is debt, right? To a certain extent, yes — debt involves an interest rate and a loan principal, and it’s a smart idea to pay your debt balances off as quickly as possible.
But there are also different kinds of debt, such as installment and revolving debt, and the type you opt for has stark implications for how you pay interest. So, what is revolving debt?
This category of debt is commonly associated with credit cards and lines of credit, but there’s more to it than that. Let’s define what the term means, explain how to calculate revolving debt interest, look at some pros and cons of taking on this kind of debt and outline what to do if you’re currently struggling with your revolving debt balances.
What exactly is revolving debt?
Let’s break things down: “Revolving” literally means that something goes around in circles, so it makes sense that revolving debt refers to loans that are ongoing in some sense.
A revolving loan is a flexible type of debt that sets a maximum credit limit you can withdraw from, but it’s up to you to choose how much you borrow and when. You might decide to take out $3,000 one month, nothing the second month, then pay everything back the third month.
However, you will face minimum payments that determine the smallest amount you can pay back each month while keeping your account in good standing.
If you don’t pay off the loan in full from month to month, you’ll accrue interest charges along the way.
Depending on your loan, you may have to pay all the money you borrowed back by a fixed date. The exact conditions you’ll face depend on the type of revolving debt you take on and the agreement you make with your lender.
The basic types of revolving debt
One of the common types of revolving debt is a credit card. With this kind of revolving debt, you have access to a certain amount of credit each month, and you won’t face any interest charges if you pay your balance in full before the payment due date. But after that point, you’ll have to pay interest on any money you still owe.
Another example is a home equity line of credit (HELOC). Things work slightly differently here: Homeowners will borrow against the equity of their house — usually not more than 85% of the home’s value. Then, they’ll pay back the amount they borrowed plus interest in monthly payments. This repayment period can last up to 20 years.
A final type of revolving debt you might hear about is a personal line of credit. This sounds like a HELOC in name but works more like a credit card in practice. You’ll be able to borrow the amount of money you need when you need it, up to a fixed amount.
However, since interest rates are lower than credit cards,these lines of credit tend to be reserved for borrowers with good credit scores — meaning a FICO score of 670 or above.
Revolving debt vs. installment debt
In contrast, installment loans are a type of debt you pay off in fixed installments, which are determined from the get-go. You must pay the fixed installment amount each month to avoid late fees.
For example, you might agree to borrow $5,000 at an APR of 10% over three years, meaning you’d make monthly payments of $161.34. This works very differently from revolving credit because you know in advance exactly how much you’ll be borrowing, what your interest rate will be and how much you’ll have to pay each month.
You’ll have to specify exactly how much you want to borrow when you apply for an installment loan and how long you want the loan term to be. You may also have to provide information about how you plan to use the funds. None of this is necessary for a credit card.
Also, unlike credit cards, installment loans may involve origination fees, which are fees for taking out the loan, and prepayment fees, which are fees for paying off the loan early.
Common types of installment loans include student loans, auto loans and personal loans.
How is the interest rate for revolving debt calculated?
Let’s delve into more detail about how exactly loan issuers calculate the interest on revolving debt.
We’ll focus on how credit card interest is calculated. You’ll need to find your average daily balance — the total balance you have on each day in the billing cycle divided by the total number of days in the billing cycle. Then, multiply this number by the daily interest rate — the APR divided by 365 or 360.
In a simple example where you only make one purchase of $50 on the first day of a 30-day billing cycle, your balance would be $50 on every single day — meaning $50 multiplied by 30 then divided by 30. In this case, the average daily balance would be $50. Then, you’d multiply $50 by the daily interest rate, which would be 0.0548% for an APR of 20% (after dividing by 365).
This means you’ll be charged 2.74 cents of interest each day. However, there may be slight differences in calculation methods. Many credit card companies compound interest every day, but some compound interest on a monthly or even an annual basis. Bear in mind that you could also be accumulating interest on late fees and other charges rather than just the balance you owe.
Many financial institutions will use similar methods for calculating interest on a revolving line of credit or HELOC once you enter your repayment period.
Is it a good idea to have revolving debt?
Ultimately, carrying debt means you risk damaging your credit score and facing high interest charges — and possibly late fees if you miss your minimum payments. However, if you’re in a position where you’re facing an emergency and need to take out a loan, a revolving credit account gives you quick access to the money you need and helps you manage your cash flow by letting you spend money in advance of when you’ll receive it.
Plus, responsible use of these accounts can actually improve your credit score, as you’ll build up a positive payment history.
In the case of a credit card, if you pay off your credit card balance before the due date each month, you won’t rack up any interest and may be able to take advantage of cashback points and other rewards. Some credit cards also come with a 0% introductory rate, which means you won’t have to owe any interest on your balance for a fixed period.
On the other hand, if you’re irresponsible and spend money you can’t afford to pay back, you could end up in a debt trap where it becomes almost impossible to earn enough to cover the interest and debt you’ve accumulated. You’re also likely to have variable interest rates, which means the interest rate on your credit card or loan could suddenly shoot up.
Plus, revolving debt options may result in a higher interest rate than installment lenders would charge. This can be especially true when it comes to credit cards.
How to manage revolving debt effectively
Although revolving loans can cause problems for borrowers who lack the means to repay them, they can be worth having if you can manage them responsibly.
One of the best things you can do is stay on top of your credit utilization ratio — the percentage of your available credit that you use each month. Your credit utilization rate is one of the most important factors in determining your FICO score, which impacts your eligibility for any future loans. Try to keep yours low by only spending a small percentage of your available credit.
Also, be careful to watch your spending. Try to avoid the temptation to use money from your revolving loan to finance unnecessary expenses, only to realize you don’t actually have enough money to cover your bill.
Instead, look at your budget and consider what you’ll be able to pay back. If you know payday is coming, there’s no harm in taking on a little debt temporarily and budgeting for the payment later on. But if you know you’re going to need your entire paycheck for bills and necessities, taking on revolving debt could be dangerous.
Finally, avoiding late payments is key to keeping your credit account in good standing and avoiding unnecessary charges.
With great flexibility comes great responsibility
Revolving debt allows you to borrow the exact amount of money you need at any given moment, offering a more flexible alternative to installment loans. However, bear in mind that anytime you take on revolving debt, it has the potential to damage your credit score and become out of control if you mismanage your personal finances. Make sure you budget and plan effectively.
If you’re looking for a way to manage your existing credit card debt, consider Tally†. As a credit card debt repayment app, Tally may be able to consolidate your higher-interest credit card balances into a lower-interest line of credit, and it can also automate payments so you can avoid late fees.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. The APR (which is the same as your interest rate) will be between 7.90% and 29.99% per year and will be based on your credit history. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.