By Karen Lynch | American Express Credit Intel Freelance Contributor
5 Min Read | August 4, 2021 in Credit Score
If “revolving credit” is one of those financial terms that makes your head spin, it shouldn’t. Chances are, you’ve already used it more than once: It’s how credit cards work, after all.
In fact, most revolving credit involves credit cards. About two-thirds of actively used credit card accounts generally carry a revolving balance, according to the Consumer Financial Protection Bureau (CFPB).1 But banks and fintechs also offer home equity lines of credit and personal lines of credit based on revolving credit. This article describes how revolving credit works for each of these financial tools.
Basically, a credit card company agrees to let you borrow money up to a certain limit, and you spend down that limit when you buy something with your card – for more detail, read “How to Increase Your Credit Limit.” Every month, you hit the reset button if you replace the money you’ve spent – aka paying your credit card bill. And then you’re back where you started: able to borrow up to your limit again. If you don’t replace what you’ve spent, you carry an unpaid balance into the next month – known as “revolving the balance” – and begin paying interest on this debt.
Credit cards serve different purposes at different times, the U.S. Federal Reserve has found. “For people who pay their balances off each month, credit cards are mainly a form of payment convenience and can be thought of more or less the same as using cash,” it stated in a report. “For those who carry a balance, however, use of the card represents borrowing and carries a cost in the interest payment and any fees that are incurred.”2
Credit card bills are expected to be paid in full or in part every month – see “How and When to Pay Your Credit Card Bill.” Of the 83% of adults with credit cards, nearly half pay their credit card bill in full every month, according to the Fed. A quarter said they carried a balance for at least a while during the previous year, and another quarter said they usually or always carried a balance.3 The average interest rate on balances stood at 16.30% as of May 2021.4
The big difference between home equity and personal lines of credit is right there in their names. The first requires you to put up your home as collateral, and the second usually requires no collateral. Both set a credit limit against which you can borrow as needs arise. And both are often used to manage cash flow, though home equity lines are often used for major home improvements, too.
Home equity line of credit: In early 2020, people had more than $900 billion in home equity lines of credit to tap into. But they had used only about two-fifths of the funds available to them. As of mid 2021, the average interest rate on a home equity line of credit was just over 4%, ranging from about 2% to 7%, depending on the borrower’s credit profile and other factors.5 Often, you can make interest-only payments for a period of time and then begin paying the principal plus interest. Online calculators can help you work out the costs of a home equity line of credit.
Personal line of credit: While you don’t typically need to put up collateral for a personal line of credit, you do need a solid credit profile. With an average interest rate of around 6% as of mid 2021, personal lines of credit are usually more expensive than home equity lines of credit but less costly than some other forms of borrowing, such as cash advances on credit cards.6 To avoid confusion between personal loans (installment loans) and personal lines of credit (revolving credit), there are a couple distinctions to remember. Personal loans provide you with money in one lump sum, at a lower interest rate, and then require fixed, regular payments. Personal lines of credit tend to have higher interest rates than personal loans, but you’re only paying interest on the amount of money you actually borrow against your credit limit. And the payment plan resembles the one used for credit card bills, including monthly minimum payments based only on what you’ve borrowed.
The other way people mainly borrow money – that doesn’t “revolve” – is with installment loans, such as mortgages, car loans, student loans, and personal loans. In the table below, we detail the differences between revolving credit and installment loans. Primarily, revolving credit provides more flexible access to funds as you need them, with monthly payments that vary as your level of borrowing changes and as national interest rates rise and fall. Installment loans are primarily taken out for big-ticket items and, as their name implies, usually repaid in regular monthly sums at fixed interest rates.
|Revolving Credit Vs. Installment Loans|
Mainly used for making small- to medium-sized purchases and managing cash flow
Mainly for big purchases, such as a home, car, or college tuition
Varying monthly payments
Same payment every month
Typically higher interest rates
Comparatively lower interest rates
Usually easier to apply and qualify
Usually more paperwork and harder to qualify
Revolving credit is a very big deal, as you can see in these statistics from various Fed reports:
Revolving credit is a staple of personal finance that provides cash flow flexibility. Two main types of revolving credit are credit cards – used typically for everyday purchases – and lines of credit – used more often for cash flow management and home improvement. Understanding revolving credit and how it works can help you decide on the best financial tool for your needs.
1 “New Report Explores the Extent of Revolving in the U.S. Credit Card Market,” Consumer Financial Protection Bureau
2 “Report on the Economic Well-Being of U.S. Households in 2019,” U.S. Federal Reserve
4 “Consumer Credit – G.19,” U.S. Federal Reserve
5 “Home Equity Line of Credit (HELOC) Rates,” Bankrate
6 “What Is a Personal Line of Credit and How Does It Work?,” Bankrate
8 “Quarterly Report on Household Debt and Credit,” U.S. Federal Reserve
9 “U.S. Consumer Debt Payments and Credit Buffers on the Eve of COVID-19,” U.S. Federal Reserve
10 “Household Debt and Credit Report,” U.S. Federal Reserve
11 “Assets and Liabilities of Commercial Banks in the United States,” U.S. Federal Reserve
12 “Pre-COVID-19 Data Shows Total Household Debt Increased in Q1, 2020, Though Growth in Non-Housing Debt Slows,” U.S. Federal Reserve