What Are Revolving Accounts & How Do They Work?
Understand revolving accounts: how they work, their unique features, and how they compare to other credit types for better financial management.
Revolving accounts are a common financial tool that can offer flexibility for managing expenses. Understanding how they differ from other credit types, such as installment loans, is important for effective financial planning and responsible credit use.
Understanding Revolving Accounts
A revolving account provides access to a credit line that replenishes as debt is paid down. This means you can borrow up to a certain limit, pay back what you owe, and then borrow again without needing a new loan application. This continuous cycle of borrowing and repayment is the “revolving” nature of the account.
This credit structure allows for repeated use of funds, providing ongoing access to capital as long as the account remains open and in good standing. The flexibility of a revolving account makes it suitable for managing fluctuating expenses.
How Revolving Accounts Function
When a revolving account is opened, a credit limit is established. As funds are used, the available credit decreases, and payments made reduce the outstanding balance, freeing up available credit for future use. Each billing cycle, an account statement is generated, showing the total balance owed and a minimum payment due. This minimum payment is typically calculated as a percentage of the outstanding balance or it might be a fixed dollar amount.
Interest is usually calculated on the average daily balance of the account. If the full balance is paid by the due date, interest charges may be avoided entirely. However, carrying a balance over to the next month results in interest accrual on that outstanding amount.
Common Types of Revolving Accounts
Credit cards are the most widely recognized form of revolving accounts, allowing consumers to make purchases up to a set limit and repay over time. As payments are made, the credit limit becomes available again for new transactions.
Personal lines of credit offer similar flexibility, providing access to funds that can be drawn as needed, often through checks or transfers to a bank account, rather than a physical card. Home equity lines of credit (HELOCs) are another common type, allowing homeowners to borrow against the equity built in their home. Like credit cards, HELOCs provide a revolving credit line where the available amount replenishes with repayments, and interest is charged only on the amount borrowed.
Revolving Accounts Compared to Installment Loans
Revolving accounts differ fundamentally from installment loans in their structure and repayment terms. With revolving credit, funds can be borrowed, repaid, and re-borrowed repeatedly, offering continuous access to a credit line. Payments on revolving accounts are variable, based on the outstanding balance, with only a minimum payment required each billing cycle. The principal balance fluctuates as new charges are made and payments are applied.
In contrast, installment loans involve borrowing a fixed lump sum that is repaid over a predetermined period through regular, fixed monthly payments. Once an installment loan is paid off, the account is closed, and any further borrowing requires a new application. Examples include mortgages, auto loans, and student loans, where the principal balance steadily declines with each scheduled payment until the loan is fully satisfied. This predictability in payment amounts and a definite payoff date are key characteristics of installment loans.