The term “revolving credit” may sound like a mysterious banking term that only a veteran banker would fully understand. In reality, though, the meaning of the phrase is fairly straightforward.
While the concept is fairly simple, how revolving accounts impact your credit score can be more complicated. Over the years, I’ve discovered that many consumers have similar questions. I often hear questions such as how many revolving accounts is ideal, how one can best utilize a given account, how revolving accounts compare to other forms of credit, etc.
It is my hope that this primer will help address these type of questions and help you better understand how to best use revolving credit to your financial advantage. The bottom line is that taking a few minutes to educate yourself about how to best leverage revolving credit could help significantly boost your credit score, which in turn could result in thousands of dollars in savings in interest or finance charges on a larger loan, such as a mortgage.
What are revolving accounts?
According to Donna Freedman, author and longtime personal finance journalist, “a revolving credit account is one you can tap again and again, up to the credit limit or line determined by the lender. For most of us, that means a credit card.”
Michael Bovee, founder of the Consumer Recovery Network, adds that “revolving credit typically defines a card account with a fluctuating balance.” Your balance is simply the amount you owe. Your card balance can go up and down based on how much you access your credit line in a given month, and also by how much you pay it down.
While credit cards are the most common type of revolving accounts, there are others. A personal line of credit, such as a home equity line of credit (HELOC), that can be drawn from, and paid down, and then drawn from again, is a good example according to Bovee. Similarly, many business owners have a business line of credit.
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The term “revolving balance” is related to but different than a revolving account. It is the amount of your balance that you don’t pay off by the due date. When you have a revolving balance on your card account, you’ll pay interest on that balance and on any new purchases you might make.
You can avoid interest charges by paying your balance in full each month. Please be aware that having high revolving balances can also lower your credit score (see below).
Revolving credit vs. installment credit
Another good way to define revolving credit is to compare it to installment credit. Freedman notes that
“installment credit is typically a loan, such as an auto loan, mortgage or student loan.”
With installment credit accounts:
- You agree to make monthly payments, or installments
- Payments are made for a set period of time, such as a mortgage that you must pay off in 15 or 30 years
- Often have lower interest rates than credit cards
- Loan is often secured by collateral, such as by your house if you get a mortgage
With revolving credit accounts:
- You make monthly payments only when you carry a balance (a revolving balance as noted above)
- Payments are not for set period of time, though you do have to pay a minimum monthly payment if you carry a balance
- Cards usually have higher average interest rates because they are unsecured- i.e. have no collateral. One notable exception are 0% intro APR cards.
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Boven adds that there are often popular perks associated with revolving card accounts that you do not see with installment accounts, such as reward points, airline miles, and cash back. Case in point, you can earn cash back rebates for virtually every dollar you spend on your reward card even if you pay off your balance in full each month.
What is a good amount of revolving credit to have?
While there is no hard and fast rule regarding how much revolving credit you should have, most experts agree that you shouldn’t have more than just a few active accounts. The reason for this isn’t due so much to the impact on your credit score, but rather due to more practical considerations. For example, having numerous accounts can be hard to manage for some consumers and can also lead to excessive spending as having open credit lines may be a source of temptation.
Boven notes that when he is helping people rebuild credit after financial setbacks, such as resolving collection accounts or filing bankruptcy, that he “typically suggests having one to two revolving credit accounts in good standing.” If nothing else, having one active account is a good emergency cushion in case of financial woes.
On the flip side, many experts agree that the number of revolving accounts shouldn’t be your main focus. Freedman explains that “how you handle credit is as important as how much credit you have.” She clarifies by stating that “the amount of credit you establish is not as important as how much of your credit you access, and how successful you are at making payments on time.”
How does revolving credit affect your credit score?
Credit scores can be complicated but the good news is that it’s fairly easy to understand how credit cards can affect your score.
Some key factors to consider:
- Payment history is the single most important factor influencing your credit score. It makes up 35% of your FICO score. Freedman notes that “if you pay late even once, you’ll notice a drop in your score; do it more than once and your score will drop further, making you a less-than-ideal candidate when you want a car loan or a mortgage.”
- It is good to have a variety of different types of credit, including revolving and installment credit. This accounts for about 10% of your score. Boven explains that “diversity of credit is an actual thing. Credit scoring models commonly reward people with a mix of credit (cards, auto, home, personal loans). That is why I often suggest people who need to rebuild their credit open one or two revolving accounts, even though they may have sworn off credit cards for good.”
- Almost one-third (30%) of your credit score is determined by your credit utilization ratio – how much of your available credit on a revolving account that you use. That should be no more than 30% per month; ideally, you’d use 10% or less.
Here’s an example of how credit utilization works:
Suppose you have $10,000 of available credit (your total credit line) between two cards. Never have more than $3,000 total charges at any given time, and if possible keep it below $1,000. Pro tip from Freedman: “Make a weekly credit card payment, to keep the balance low (or nonexistent).”
➤ SEE MORE:Should you make a credit card payment twice a month?
Final thoughts
Revolving credit accounts are convenient and can financially empower you. I really love earning cash back on purchases and enjoying many other credit card benefits with my accounts.
However, irresponsible usage can have a devastating effect on your personal finances. Not only can your score suffer, but you might also suffer from excessive card debt.
As you might expect, my advice is simple. Be credit savvy and use cards to your financial advantage. However, if you do start heading in the wrong direction, stop using your card(s) immediately and seek outside help if you’re unable to successfully use a self-help approach.
Happy charging!
