Here’s How a Revolving Line of Credit Works
Revolving lines of credit might not get as much attention as other types of loans, but understanding how they work could help you manage your credit better.
May 16, 2022
When you’re trying to figure out which type of loan to take out, understanding the differences between each kind can get confusing. For example, what’s the difference between revolving and non-revolving lines of credit? And, more importantly, how can you manage them effectively so that you end up with a healthy bank account and a good credit score?
If you’ve found yourself pondering any of the above, the good news is that you’re already asking the right questions. Get answers to them one by one below, so you’ll know how to take ownership of your finances.
What is a revolving line of credit?
A revolving line of credit is a loan that gives you access to a certain amount of credit, which you can access if and when you need it. You can then continue to borrow more and repay your balance over time; the only restriction is that you can’t take out more money than the specified maximum amount.
For example, a financial institution might give you up to $10,000 of available credit. You could then choose to borrow $5,000 one month, $4,000 the next month, pay back $5,000 the next month, and borrow $3,000 the following month. You could continue along the same pattern for the foreseeable future.
As with any loan, you’ll accumulate interest after borrowing, so you’ll need to pay this interest back to your lender as well as the initial loan amount.
Types of revolving lines of credit
A revolving line of credit is also called revolving credit, and there are a few different types:
Personal line of credit: The most basic and common example, which gives you access to a revolving line of credit for personal use
Business line of credit: A popular type of business financing that offers the same thing but for business use
Home equity line of credit (HELOC): A type of home equity loan that allows homeowners to borrow against the equity in their house using a revolving line of credit
Revolving lines of credit can be secured (meaning you have to offer collateral to borrow) or unsecured (meaning there’s no need for collateral).
Opting for a secured loan can be a useful way to land a lower interest rate since it gives your lender more security that you’ll pay them back.
Credit cards are similar. A credit card gives you access to revolving credit. However, a credit card is used to finance specific purchases, while a revolving line of credit lets you borrow an amount of money before you buy anything. There are also some other small differences:
Lines of credit tend to have lower interest rates than credit cards
Only credit cards offer rewards or cash back programs
What is the difference between revolving and non-revolving lines of credit?
Since “line of credit” makes up the bulk of the terms “revolving line of credit” and “non-revolving line of credit,” it’s no big surprise that people tend to get the two terms mixed up.
In both cases, you’ll have a credit limit(e.g, $10,000), which determines how much you can borrow at once. Unlike installment loans, such as personal loans or auto loans, you can borrow as much or as little as you want up to that limit and in separate chunks, instead of receiving a lump sum of money upfront.
Yet there’s a key difference: When you take out a non-revolving line of credit, you can only borrow up to your available credit once. The lender won’t renew or replenish your line of credit once you pay the money back, as is the case with a revolving line of credit. Instead, they’ll close your account, and you’ll have to open a new credit account if you want to borrow the same amount again.
Non-revolving lines of credit consist of two stages:
A draw period: When you can borrow money
A repayment period: When you pay the money back, plus interest
Although revolving lines of credit can also feature these periods, the credit limit is “revolving,” so you’ll continue to replenish the amount of funds you can borrow if you pay back part of the principal. Revolving lines of credit are therefore one of the more flexible ways to borrow.
Impact of a revolving line of credit on your credit score
Before you take out any type of loan, it’s wise to think about the impact it will have on your financial position over the long run. Your credit score is a big part of that because it influences your chances of being approved for future loans and being offered a low APR.
So, what kind of impact will a revolving line of credit have on your credit score?
The FICO Score is a particularly popular credit scoring model, and it accounts for several factors which determine what credit score to give a borrower.
Here’s how a revolving line of credit may influence each of these credit scoring factors:
Payment history: Your credit score may improve if you show you can make on-time payments after taking out your credit line (but the reverse happens if you fail to do so).
Amounts owed: Your credit utilization rate (percentage of available credit that you’re using) impacts your credit score. Borrowing a high percentage of what’s available to you could harm your credit score.
Length of credit history: Having a long credit history is good, so opening a revolving line of credit and then closing it may have a negative effect.
Credit mix: A revolving line of credit can diversify your credit mix, which credit bureaus consider to be a positive. This would be useful if you currently only have installment loans.
New credit: This factor would likely only be impacted if you were applying for lots of revolving lines of credit over a short period.
In summary, a revolving line of credit can be beneficial for your credit score if you use it responsibly.
How to manage a revolving line of credit
A revolving line of credit can be a great way to manage your cash flow, but it’s a good idea to stay on top of everything to avoid hurting your credit score (and your finances in general).
When you take out a revolving line of credit, it’s tempting to focus on how much you’ll be able to access over the short term, but it’s crucial to consider your repayments from the get-go. And remember, you won’t just have to cover the initial loan amount, but you’ll also have to pay interest on the balance. So, budget for this in advance.
Then, once you get into the repayment period for your loan, it’s important to make your minimum payments on time. To do this, it can help to set up automatic payments from your bank account.
If you’re worried about your credit utilization rate, you may be able to improve your situation by asking your lender to increase your available credit.
Look before you borrow
A revolving line of credit is a popular type of loan for a reason: It can help small business owners or individuals finance essential expenses when they don’t have cash on hand.
However, before you open a revolving credit account, be mindful of the impact it could have on your credit score — especially if the line of credit leads to late payments or a high credit utilization rate.
If you have credit card debt and you’re trying to get your personal finances in shape, Tally† might be able to help. Tally is a credit card repayment app that can take your higher-interest credit card debt and consolidate it into a lower-interest revolving line of credit, so you can take control of your financial future.
†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.