Revolving credit is a flexible borrowing tool. Here’s how to use it best:
What is revolving credit?
If you have a credit card, you’ll likely have some concept of revolving credit, even if the term doesn’t sound familiar to you at first. Revolving credit is a type of financing that allows you to access money up to a predetermined credit limit. Once you repay what you’ve used, you can borrow it again instantly, without reapplying for the credit from your bank. If you don’t fully pay off what you owe each month, your outstanding balance will accrue different levels of interest depending on the type of account.
What are the advantages and potential drawbacks of revolving credit?
Revolving credit can be useful because it generally does not expire if you remain in good standing with your bank, primarily with a credit card. The longer you have a credit card, the more likely it is that your limit will be increased over time. If you’ve shown your bank that through your years with them, you always reliably pay back your debts, they may reward you by increasing your limit. This in turn encourages you to use the account to finance large purchases.
So convenient, right? This simplicity also demands careful consideration. Because it’s easy to use, and even easier to rack up your spending, revolving credit typically comes with high interest rates to discourage you from carrying a balance over long periods. This interest rate on a credit card will be higher than the rate of a simple installment loan. The average personal loan rate in 2023 is between five and ten per cent a month, whereas a credit card will typically accrue 20 per cent in interest every month. That can add up fast over time, so it’s important to responsibly manage how much you spend on a credit card throughout the year. Also, you can’t just let your balance owed creep up. Monthly payments are required to keep you in good financial standing with your lender and avoid your account going into collections, for example.
The most common kinds of revolving credit are:
Credit cards: An account like this help you make bigger purchases that you can pay back over time, without going to the bank to get a loan each time you are considering spending a significant, but not life-changing, amount of money. Credit cards also typically come with rewards, like cash back, points for various types of rewards or miles to be used on airplane travel.
Personal line of credit: This type of account allows you to borrow money up to a certain limit during a set period that typically lasts three to five years. As you pay off what you’ve spent, the balance becomes instantly available again during the “draw period.” When this ends, you will repay what is outstanding by making fixed monthly payments into the account.
Home equity line of credit (HELOC): A HELOC works just like a personal line of credit, but uses your home as collateral. You borrow against your home’s equity, meaning its appraised value amount that exceeds the unpaid balance on your mortgage. Most HELOCs let you borrow between 60 and 85 per cent of your home’s equity during the draw period, which typically lasts five to 10 years. The repayment period lasts between 10 and 20 years.
Revolving credit can be secured or unsecured. A HELOC is an example of a secured line of credit because it is backed by collateral in the form of your house. The interest rate on a secured line of credit is usually lower because this type of account is not as risky for the lender.
What are the key features and components of revolving credit?
There are four primary components of revolving credit that are important to understand on your financial journey.
Credit limits: A lender will take your credit score, current income, and employment stability into consideration when they are deciding on your spending ceiling. Once they calculate it, you will be informed how much you can spend on revolving credit
Interest rates: By having a good credit score, you may qualify for lower interest rates on your revolving credit. This means if your score shows good creditworthiness, you may pay less interest if you carry over a balance month to month.
Fees: A merchant may add a surcharge on payments made by debit or credit cards and apply them each time you use your card to make a transaction. The fee will be disclosed to a customer before a purchase is made. Banks may also apply annual or monthly fees just for having the card.
Repayment terms: are the rules set by your lender that determine how you will repay what you owe over time. These terms will be set out by your lender when you open the account.
How does revolving credit compare to a line of credit?
A line of credit is a type of revolving credit that is typically used for projects where the total amount is difficult to estimate at the outset, like a home renovation. You can write cheques billed to your line of credit, something you can’t do on a credit card. A line of credit has a certain pre-determined availability for its use and will close after a period of several years. This won’t happen to a credit card, which you can renew after a pre-determined period (check the expiration date on your physical card).
What are the requirements and qualifications for obtaining revolving credit?
You will be required to submit a substantial amount of personal information to a lender so that they can verify your identity. hen considering you for revolving credit, the financial institution will consider the information on your credit report, including your credit history, payment behaviour, and outstanding debts to all other lenders. In Canada, banks typically require a minimum household income between $35,000 and $50,000 to approve a line of credit.
How can individuals use revolving credit responsibly to positively influence credit scores?
Here are a few strategies you can use to be sure you are using your revolving credit as responsibly as possible. By following these tips and tricks, you can lower your risk of potentially damaging your overall credit score.
Make your payments on time. Missed payments are the fastest way to damage your score. Set yourself up for success and arrange for your bills to be automatically paid each month.
Keep your credit utilization ratio low. Your ratio is calculated by dividing the amount of revolving credit you are using by the amount of revolving credit you have in total. Try to keep this ratio below 30 percent to prevent it from negatively impacting your score.
Leave your revolving credit accounts open. If you close an account, the amount of revolving credit at your disposal drops. This can drive up your credit utilization ratio, so even if you aren’t actively using an account at the moment, it’s best to keep it in play over time. By building good credit history over time, lenders will see how well you manage debt and will be more likely to approve you for loans in the future.
Minimize inquiries made on your account. When a potential lender considers an application you’ve made, they may make an official request to view your credit report. These queries into your financial history can lower your credit score by an average of five points. These can add up if you make requests from multiple lenders because this suggests you are shopping around for a lender, and could indicate you are financially squeezed. This raises red flags to financial institutions, as it suggests you may not be able to pay back your loan.
Financial institutions want to know how you have managed different accounts over time. By having different types of well-managed credit in your financial portfolio, called a credit mix, lenders may consider you to have better creditworthiness, which positively impacts your credit score.
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Morgan Sevareid-Bocknek is a Toronto-based journalist. She is an investigative reporter at the Toronto Star and has reported for The Associated Press and The Globe and Mail.