Debt Consolidation

What Is Revolving Debt, and How Is It Different From Installment Debt?

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If you shop with a credit card or borrow funds from a line of credit, you’re carrying revolving debt. While your interest rate on that debt, minimum monthly payments and amount owed may fluctuate, you can keep drawing on those funds for as long as your accounts are open and you have available credit.

In contrast, installment debt must be paid off over a set period of time, at rates and monthly payment amounts you’ve agreed to up front. Both types of debt carry pros and cons, including how they affect your credit rating. We break them down in further detail below.

What is revolving debt?

A credit card is the most common example of revolving debt. It lets you borrow a certain amount of money, but you only have to pay back a minimum percentage of it each month, plus interest (though interest payment can be avoided by paying in full). Because you’re not obligated to pay off the balance in full at any time, you can keep borrowing and re-borrowing from your card, as long as you don’t exceed the total amount of credit you’ve been granted.

For example, if you max out a credit card that has a limit of $5,000 and pay back $3,000, you can borrow that $3,000 back again. If you pay it all off, you’ll have access to the full $5,000 without needing to reapply for new credit.

While having continuous access to extra funds can be convenient — especially in an emergency — revolving debt can come at a higher cost than installment debt. Credit cards and lines of credit usually come with variable interest rates that can be higher than what you might pay with installment credit like a personal loan or car loan.

Pros and cons of revolving credit
Pros Cons
  1. Can borrow and re-borrow unlimited number of times as long as you don’t exceed the credit limit
  2. Can be open-ended with no set time limit to pay back the full amount
  3. May include a grace period for paying back funds without incurring interest charges
  4. Can be a great way to manage cash flow if used responsibly
  1. High variable interest rates can make repayment expensive
  2. May negatively impact your credit score depending on how much credit you utilize
  3. May offer lower limits than other types of credit

3 examples of revolving debt

Common types of revolving debt
Type How it works
Credit card The credit card issuer allows you to borrow up to a set amount. You’re responsible for paying back a percentage of whatever you borrow each month, plus interest if you do not pay off the balance within the grace period. These payment amounts, as well as the interest rate, may change from month to month.
Personal or business line of credit The financial institution gives you an unsecured loan from which you may withdraw funds as needed through a card, checks or transfers to a checking account. Interest rates may fluctuate and extra fees may apply for each transaction. Because it’s not secured by an asset, you could pay higher interest rates. Unlike credit cards, you’re unlikely to benefit from a grace period.
Home equity line of credit (HELOC) The financial institution decides how much you can borrow based on the equity you have in your home. You’re given a set time limit by which you must pay back the funds. Like a mortgage, if you default on your HELOC payments, you could lose your home. However, you could get a lower interest rate for using your home to guarantee the loan.

Credit card

If you don’t have any credit history, you could start building it by applying for a secured credit card through your current bank or credit union. This involves putting down a deposit that becomes your credit limit. Another alternative is to apply for a starter credit card with a very small limit. Once you’ve built up a positive payment history through either of these options, you can apply for a traditional unsecured credit card.

To find a card with the lowest possible fees and APR for you, do some comparison shopping. Once you identify the best card for your needs, you’ll need to fill out an application to determine if you qualify. To be eligible, you’ll need to meet requirements such as:

  1. Being a U.S. citizen or permanent resident, or have an Individual Taxpayer Identification Number
  2. Showing proof of income
  3. Submitting to a credit check

Personal line of credit

To apply for a personal line of credit, you should start exploring your options at your existing financial institution. However, some banks and credit unions may not require you to have a checking account with them to qualify for a line of credit.

Once you identify where you want to apply, you’ll have to complete an application and provide supporting information such as:

  1. Pay stubs
  2. Tax forms, like W-2s

Be prepared for the lender to look at your credit score, payment history and debt-to-income ratio before they make their decision.

Home equity line of credit

Think of a home equity line of credit (HELOC) like a second mortgage — indeed, it’s a loan on a property that’s already been mortgaged. As a revolving credit line, it allows you to draw funds from a credit limit based on the value of your home. Interest rates are also variable.

Unlike a credit card, however, you have a set period of time to make charges, known as the draw period. Lenders may require an initial draw amount, and there can be a maintenance or annual fee. Once the repayment period begins — usually after about 10 years — you’ll have to pay off the balance within a certain time frame or risk losing your home.

How much home equity do I have? To get an idea of how much home equity you might be able to access, you should first appraise your home to determine its current value. Once you have this number, subtract your mortgage balance from it. The remaining amount is your available home equity.

[Home value] – [mortgage balance] = Home equity

To apply for a HELOC, lenders will want to see:

  1. Your current mortgage statements
  2. Paperwork from your original purchase
  3. Credit score
  4. Income

A home appraisal may also be required, though some lenders will waive this requirement. Keep in mind that a HELOC can come with significant closing fees in addition to the APR, so it’s important to shop around to get the best deal.

Revolving vs. installment debt: Key differences

Key takeaways:

  1. Revolving debt tends to have higher interest rates than installment debt
  2. Installment debt must be paid back within a set period of time; revolving credit may be extended indefinitely
  3. Installment loans do not count toward your credit utilization ratio

Student loans, mortgages, auto loans and personal loans are some of the most common examples of installment credit. Because your monthly payments are always the same and your interest rate never changes, it may be easier to budget with installment debt.

One advantage of installment loans is that interest rates tend to be lower than for revolving credit. However, they may also be harder to qualify for and can sometimes require collateral like the equity in your home or your savings account.

While having a set period of time to pay back your installment loan can keep you on track, some borrowers may prefer the flexibility of revolving credit and the ability to make just a minimum payment when money is tight. Depending on the product, a revolving credit account may be open indefinitely, but installment credit is only offered temporarily.

How revolving and installment debt can affect your credit

Revolving debt can either help or hurt your credit score, depending on how you use it. Your FICO Score — the most commonly used credit scoring model by lenders — is determined by a number of factors, including:

  1. Your payment history (35%)
  2. Amounts you owe (30%)
  3. How long your credit accounts have been open (15%)
  4. New credit you’ve obtained (10%)
  5. Your mix of credit accounts (10%)

If you’re able to consistently demonstrate a credit utilization rate of less than 30% — meaning, you only use less than one-third of the debt available to you — this can help increase your score. However, the variable interest rates that come with revolving debt could cause you to miss a payment, which would make your score decrease quickly.

Showing that you’re able to responsibly use a diverse mix of revolving and installment debt can give your score a modest boost since that accounts for 10% of it. Another advantage to taking on installment credit is that it doesn’t count toward your credit utilization ratio. The lower this ratio, the higher your score could be.

However, your debt-to-income ratio takes all your debts into account. If lenders feel you don’t have sufficient income to pay off your existing debts, this could affect your ability to get funding in the future.

 

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