Revolving Debt

Debt revolving

As of March 2019, revolving debt accounted for 26 percent of the $4.05 trillion outstanding consumer debt in the U.S., according to the Federal Reserve. Revolving debt is money that you owe on an account that’s been borrowed against an established credit limit. This type of debt most often comes in the form of credit cards, which require regular monthly payment but have an otherwise unlimited term. Specifically, this means no fixed end date by which you have to pay back the entirety of borrowed funds.

Revolving debt is ideal for those with regular cash flow fluctuations, whether individuals or businesses, as it offers flexibility in use and in repayment terms. When used responsibly, having revolving credit accounts could be a good way to build credit, but using lines of credit carelessly could negatively impact your credit score.

What is Revolving Debt? 

The revolving debt definition is straightforward, since revolving debt simply comes from having lines of revolving credit. Revolving debt refers to the money you owe on revolving credit accounts, which usually takes the form of credit card accounts. Though they’re the most common way to accumulate revolving debt, credit cards are not the only revolving credit accounts available. Other forms of revolving debt include personal lines of credit, such as home equity lines of credit (HELOC).

Revolving Credit Account Limits

To assign a credit limit for revolving debt, lenders take into consideration an individual or corporation’s ability to reliably pay back what is borrowed. For an individual borrower, a lender will assess credit history and income level, while for a business seeking a line of revolving debt, financial institutions will look at financial statements like balance and income statements to determine the appropriate amount of credit to issue.

Imagine you have a $3,000 limit on a credit card. You can use the card to make purchases up to that limit, and once you repay either the monthly minimum payment or higher, the funds are available immediately to be borrowed again. However, you’re not required to pay back the full amount you borrow. For instance, if you spend $500 of that $3000 limit but only pay back $200 the following month, you won’t face a penalty. You’ll have to pay back at least the set minimum, which includes interest charged on the amount you spend. Therefore, the cycle of revolving debt can be continuous.

The minimum you can expect to pay back on revolving debt each month is not necessarily static—if you have a month of high spending and amass a large amount of revolving debt, you may have to make a higher minimum payment in that particular month.

Revolving Debt and Interest

Revolving debt—unless it’s a home equity line of credit (HELOC)— is typically unsecured, which means that financial institutions are unable to claim your property if you fail to make payments. Additionally, though revolving credit has flexible terms, it does come with a caveat: potentially high interest rates. You can avoid exorbitant interest payments by paying your revolving debt balance in full each month, otherwise, you’ll end up paying more than you initially borrowed.

The interest rate on a revolving credit account is typically variable and may be adjusted. You can also apply for a higher credit limit if you’re in good standing with creditors.

Revolving Debt vs. Installment Debt

We’ve broken down revolving debt, but how does it compare to installment debt?

While revolving debt has an open-ended repayment term, installment debt must be repaid under a pre-established term with set payments that don’t change over time. In other words, you pay down the loan in level amounts (installments) each month. When you take on installment debt, you can’t borrow more against the loan, which makes it a non-revolving line of credit.

Installment debt is predictable, since you must pay it back on a locked in schedule with an absolute end date. The payments are fixed, meaning that in some installment loan cases, you’ll receive a prepayment penalty if you pay more than the agreed upon amount each month.

Types of Installment Debt

Some common examples of installment debt include home mortgages, student loans, and auto loans. Once the installment debt is paid off, the credit account is closed and can’t be borrowed from again. You’d have to apply for a new installment loan and start the approval process again.

Revolving debt—unless it’s a home equity line of credit— is typically unsecured, which means that financial institutions are unable to claim your property if you fail to make payments. This is what makes revolving lines of credit riskier in the eyes of creditors. Conversely, installment debt is sometimes secured, meaning that it can be tied to collateral, whether a car or a house, that can be repossessed if you default on the installment loan.

The amount of the installment loan is predetermined, as you borrow a fixed amount in a lump sum at the get-go. Installment debt usually comes with lower interest rates than revolving debt because it is less risky for a creditor to extend to borrowers (since it’s usually secured). Installment credit is also useful for especially large purchases because creditors typically limit the amount available to borrow on revolving accounts, since the latter bears more risk.

Revolving Debt and Your Credit Score

Scoring agencies look at revolving debt to get a sense of your creditworthiness, since there is more risk involved than with installment debt. Namely, revolving debt isn’t backed by anything a lender could reclaim if you fail to make payments.

Credit card accounts, the source of most revolving debt, can drastically affect your credit score depending on how carefully you use them. Though they are useful for the flexibility that lets you spend when you need it, revolving accounts can hurt your credit score if used improperly. For example, allowing your revolving debt to rack up with high balances carried across several months leads to a higher credit utilization—which makes up a significant amount of your credit score.

If used correctly, taking on revolving debt can be a good way to build credit and can possibly help you reach a higher credit score. Since payment history is the most significant factor that influences your credit score, it’s important to make payments on time each month, even if you can only pay the minimum amount. Any missed payments will cause your score to drastically suffer.

Unused funds on a revolving credit account that fall under the borrower’s credit limit are referred to as available credit. The amount of available credit you have is important to both your VantageScore and FICO score, since using a high percentage (over 30 percent) of your available balance could have negative implications for your credit score. On a similar thread, since mix of account types is taken into consideration to determine your credit score, having both revolving and non-revolving (installment) debt could potentially help your score.

If you’re trying to improve your credit score and have both revolving debt and installment debt, it’s a wise idea to pay off revolving debt first since it typically will have higher interest rates and have more of an impact on your score.

Summing Up

Responsible management of revolving debt can be a flexible way to build credit if you make regular on-time payments on your revolving accounts. It can be beneficial to use credit cards, the most common form of revolving debt, because they have open-ended repayment durations and you don’t have to constantly reapply for credit as you would with installment debt.

Revolving debt can have either positive or detrimental effects on your credit score. Racking up high levels of revolving debt or missing payments can hurt your credit score while keeping your credit utilization below 30 percent may help to improve it. Though revolving debt accounts for a significant amount of the debt owed by U.S. consumers, revolving lines of credit can be convenient tools for corporations and individuals alike— so long as you use only the amount of your credit limit that you can reasonably afford.

Sources:

Investopedia 1, 2 | Corporate Finance Institution | SmartAsset

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