You've got bills, bills, bills -- but payday doesn't always align with those due dates. And what if you need to make a big-ticket purchase that you just don't have the cash for right now? You might need revolving credit.
How Revolving Credit Is Different From an Installment Loan
Revolving credit is when a lender extends credit to you that remains the same amount month over month. You're free to use as much or as little of that credit line as you wish on any purchase you could make with cash. At the end of each month, you're sent a bill for the balance. If you don't pay it off in full, you pay interest on the remainder.
"A classic example of revolving credit is a credit card," explains Brian Davis, personal finance columnist and co-founder of Spark Rental, an educational site for real estate investors. "The balance goes up and down, as the consumer either pays it down or charges it up. The monthly payment fluctuates alongside the balance."
But if you need to borrow money for a specific purpose -- say, to buy a car or to cover college tuition -- you can take out an installment loan. Essentially, you borrow one big chunk of money and pay it off in monthly installments until the debt is gone.
"Perhaps the best illustration of revolving credit versus an installment loan is a home equity line of credit versus a [lump sum] home equity loan," Davis says. "A HELOC is a revolving line of credit that homeowners can draw on or pay down." But a lump sum home equity loan has a fixed loan amount and repayment term -- "it's a classic installment loan," he says.
Another major difference between revolving credit and installment loans is the interest rate. According to Investopedia, credit card rates tend to fall within a range of 9 to 25 percent, whereas you may find much lower rates of around 2 to 18 percent on installment loans.
So, why might you choose revolving credit over an installment loan? Revolving credit is best when you want the flexibility to spend on credit month over month, without a specific purchase established up front. And in the case of credit cards, it can be beneficial to spend on credit to earn rewards points and cash back -- just as long as you pay the balance off on time every month.
How Revolving Credit Affects Your Credit Score
Any time you make a purchase on credit, it has an impact on your FICO credit score, which is the score most commonly used by lenders. How you handle that credit will determine whether the impact is positive or negative. Here's how revolving credit specifically can affect your credit score.
Credit bureaus consider several factors when calculating your FICO credit score. The biggest, accounting for 35 percent of your score, is your payment history, according to myFICO.
Missing payments on credit cards or other revolving credit accounts can have a dramatic and lasting impact on your score. Equifax, one of the three major consumer credit bureaus, reports that, if you have a high FICO credit score, just one payment made 30 days late could knock down your credit score by as much as 90 to 110 points.
On the other hand, if you consistently make your payments by the due date, you will build a positive credit history that only strengthens your score over time.
The second-most-important factor in determining your FICO score is the amounts owed, which accounts for 30 percent of your score. Relying too heavily on the credit extended to you is a major red flag to lenders, since it might appear you don't have enough money to keep up with expenses. In fact, the last thing you want to do is max out your credit lines.
Your credit utilization ratio is a measure of how much credit you're using. To find your credit utilization ratio, divide your total outstanding balances by the total amount of credit extended to you.
"You should look to keep your credit utilization ratio under 30 percent," says Cal Cook, consumer finance investigator at watchdog site ConsumerSafety.org. This means that if you have a total credit limit of $3,000, you should keep your outstanding debt on your cards under about $1,000 to be safe.
You should also keep in mind that your credit utilization can be high even if you pay off your balance every month. That's because your balance is often reported to the credit bureaus on a date other than your bill's due date. For that reason, it's best to avoid running up a large balance, even if you plan to pay it off in a couple weeks.
Credit History and New Credit
Creditors like to see a long, steady history of using credit responsibly, which is why your credit history makes up 15 percent of your FICO score. The older your credit accounts, including credit cards and other types of revolving credit, the better.
At the same time, too many accounts opened within a short period of time will not only lower the average age of your credit but will signal to lenders that you could be desperate for more credit. That's why new credit makes up 10 percent of your FICO score.
If you apply for revolving credit and are denied, it's best to wait a while and work on improving your credit before applying again. And if you are approved, financial site NerdWallet says to avoid applying for any more credit for about six months.
The final 10 percent of your credit score is based on your credit mix. "Having different types of credit is actually a positive for your credit score, provided all debt is paid on time," says Cook. "Someone who has a history paying off both installment and revolving credit on time has proven they're financially responsible, while someone who has only dealt with one type of credit is more of a risk to lenders."
So, if you have limited experience with credit -- maybe you only have student loans from your early adult years -- it could be beneficial to diversify with a revolving credit account, such as a credit card.
How to Use Revolving Credit to Your Advantage
Revolving credit can help you manage expenses before your next paycheck arrives. Plus, using rewards credit cards on purchases you have to make anyway is a great way to put money back in your pocket. Just make sure you're doing it right:
-- Keep balances low. With a credit card or other types of credit, you're able to use up to 100 percent of the credit extended to you. But that doesn't mean you should. Maxing out your credit will lower your credit score. Keep balances low throughout the month -- ideally, under 30 percent utilization -- to ensure you maintain healthy credit.
-- Pay off balances every month. A first-time late payment on your credit card can result in a fee as high as $27. Plus, some issuers will raise your annual percentage rate on future purchases as a penalty. The worst consequence, however, is a potentially severe drop in your credit score. Staying on top of your bills is the most impactive thing you can do to maintain good credit.
-- Avoid too many applications for revolving credit. Before applying for a credit card or other type of credit, be sure your credit score is in good shape to avoid being rejected. And if you are approved, space out future applications to avoid a ding to your credit score.
Revolving credit can be a useful tool or a drag on your credit score, depending how you use it. If you're a responsible spender and pay your bills on time, you should be able to use credit to your advantage while also building a good credit score. Now that's a win-win.
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