How Revolving Credit Works

Basically, there are two ways to borrow money: closed-end credit and open-end credit. A loan is an example of closed-end credit. When applying for a loan, you and the bank agree on the exact amount of money you will borrow, the exact amount of time you'll have to pay it back and at what interest rate you'll be charged. These are called the terms of the loan. A loan is called closed-end credit because there's a set date when all of the debt needs to be paid back in full, plus interest.

A loan is typically repaid through fixed monthly payments. Each monthly payment includes both principal and interest. A mortgage is a good example of a closed-end loan. If you take out a 30-year mortgage for $100,000 at an annual interest rate of 8 percent, your monthly mortgage payment would be $733.76. After 30 years, you would have paid back the entire $100,000 plus interest ($164,153).

Revolving credit is called open-end credit because the length of the loan isn't fixed -- it's ongoing. The two most important terms of a revolving credit loan are the line of credit and the interest rate. The line of credit is similar to a credit card limit. Essentially, it's the maximum amount of money you can borrow at any given time. The interesting thing about credit cards is that the issuer of the card can change your credit limit and interest rate at any time. But we'll talk more about this later.

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­With revolving credit, there are no fixed monthly payments. You have several payment options every month. Your monthly statement will list all of the money you've borrowed from your line of credit in the past month (the total amount of the purchases you've made). This is your balance. If you have the cash available, it's wise to pay back the full balance immediately. Then you won't be charged interest for carrying a portion of your balance into the next month.

Even if you can't pay the full amount, you are required to pay at least a minimum percentage of the balance, typically between two and four percent for credit cards. When the next month rolls around, your statement will show the new balance plus the interest charged on the old balance. Once again, you can choose to pay it all off or pay only a portion of the balance. You'll continue to make monthly payments on revolving credit accounts until you pay for all outstanding charges and cancel the account.

A home equity line of credit is another popular form of revolving credit. Like with credit cards, a credit limit is placed on this account. The credit limit is based on the equity in your home. You can calculate equity by subtracting any outstanding mortgage payments from the current value of your home. So the longer you've been making mortgage payments, the more equity you'll have built up in your house.

With a home equity line of credit, you can borrow cash whenever you need to make home repairs or improvements without having to apply for separate home equity loans. There are also no fixed monthly payments, so you can pay it back when the cash is available.

So is revolving credit just a credit trap? Or are there advantages to these accounts? Find out on the next page.

The greatest advantage of revolving credit is that it's available when you need it. You don't need to apply for a loan every time you don't have enough cash to buy something. You can also use as much or as little credit from your line of credit as you want. With a credit card, you can buy a pack of gum as easily as you can purchase a pair of Jet Skis.

Revolving credit can also be used for any type of purchase. Mortgages, for example, are only good for buying a home, and car loans can only be applied to automobiles. But even though a home equity line of credit is based on the equity in your home, it can be used for virtually any purchase. Most people use home equity lines of credit to finance home improvement projects, but you could also use the cash as a low-interest loan to fund your next vacation or to pay off higher-interest debt from a credit card.

­Revolving credit offers one financial solution to people who have steady jobs but irregular paychecks. Perhaps you're a successful car salesman, but some months are slower than others. With revolving credit, you can buy things on credit now and pay for them when you have the money on hand after a few big sales.

One of the greatest advantages of credit cards -- the most popular form of revolving credit -- is that they're safer to carry around than cash and they're accepted just about everywhere. Imagine if you had to keep enough cash on hand to pay for gas, groceries, movie tickets, parking and all your other incidental purchases.

But the convenience of revolving credit doesn't always outweigh its disadvantages. The greatest disadvantage of revolving credit is the temptation to spend money you don't have. For some consumers, a $10,000 credit limit is simply too hard to resist. They buy now without any thought as to how they'll pay later. And when they max out one credit card, they simply apply for another and start all over again. One in 10 Americans has more than 10 credit card accounts [source: CreditCard.com].

Sometimes revolving credit can be a little too flexible. Without fixed payments, many people wait too long to pay off their balances. Compound interest adds up fast, especially with revolving balances totaling thousands of dollars.

­Another danger of revolving credit (and this applies mostly to credit cards) is that the terms of the loan aren't fixed. If you read the fine print of your credit card agreement, you'll see that the lender can change your credit limit and interest rate any time. The lender is bound only to notify you in writing of the change. Your credit score may affect your credit limit and interest rate. If your credit score changes due to defaulted payments to other lenders, you become a risky borrower. Your interest usually changes to correspond to your risk level, that is, when and how quickly you can be counted on to pay the lender back.

If you understand the risks and benefits of your revolving credit account, you can certainly use it to your advantage. For more information on credit, debt and related topics, follow the links on the next page.