Using Revolving Credit
When you apply for a loan or credit card, you are applying for credit. The two major types of credit are open-end and closed-end credit. Because it allows you to borrow up to an authorized amount on a continuous basis, open-end credit is sometimes called revolving credit.
Credit cards and home equity lines of credit are the two major types of revolving credit. The authorized amount that credit-card issuers allow you to borrow is your credit limit. You can borrow up to the amount of your limit. You may be able to negotiate with the card issuer or bank to borrow more than your limit for short periods of time. This privilege is called an overdraft privilege.
A credit card is issued to you by a credit-card company if it approves your credit application. If you are establishing credit, you may receive a small credit limit at first. Over time, if you pay your bills regularly, your credit limit is increased. The following table shows how a credit card works over six billing periods. The card is issued with an initial credit limit of $2,500:
|Balance||Charges||Payments||New balance||Available credit|
As the table shows, the borrower takes his first draw in the second billing period for $300. The draw reduces his available credit to $2,200. In the third billing period, he draws down $500 and makes a $100 payment at the end of the period. He continues to draw down his available credit until the sixth billing period. He pays off the entire balance, including accrued interest, "cleaning up" his balance. As a result of the cleaned-up balance, his available credit is restored to the original credit limit of $2,500.
Revolving credit works like a reservoir: As you make charges, your available credit is reduced. As you make payments that lower your card balance, your available credit is replenished.
With some forms or revolving credit, the lender requires you to pay off your card balance from time to time. The cleanup period is the frequency that the lender requires you to pay off your balance. Cleanup periods are not always used. Lenders use them to ensure that the borrower continues to have the means of paying off the debt.
Credit cards generally do not have cleanup periods. A major exception is American Express and similar cards. These cards are not truly credit cards since they do not extend credit for more than one billing period. Instead, you are required to pay your balance in full every billing period.
Home equity lines and personal lines of credit are similar to credit cards. Personal lines of credit are forms of unsecured revolving credit. Home equity lines of credit are secured by the equity in the borrower's home. For example, a bank may offer a credit line with a credit limit of $50,000 to a homeowner who has built up substantial home equity. In exchange, the lender takes a mortgage lien on the home to secure the loan.
Similar to credit cards, a line of credit allows the borrower to take draws and use the funds, up to the authorized credit limit. If the borrower pays down the balance, available credit increases by an amount that is equal to the amount paid down.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.