Revolving Credit vs. Loans
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.
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.