Terminology can get pretty confusing in the world of credit reports. An example of this is the idea of revolving accounts. To you, these could simply be your credit cards or lines of credit. To the way your credit scores are formulated, the designation can make all the difference. Read on to learn about what a revolving account is and why it matters.
What Is a Revolving Account?
At first glance, you might think there are only two types of debt: secured and unsecured. Secured debt is tied to collateral that can be taken back if the debt goes unpaid (think a loan for a car or a home). Unsecured debt isn’t tied to collateral, which is why it often comes with higher interest rates (think credit cards or lines of credit).
But these aren’t the only types that debt can be broken into. Whether secured or unsecured, debt can also be classified as either revolving or installment.
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Revolving debt is a line of credit you can borrow from any time you need to, and that you can pay off at your leisure as long as you pay your minimum monthly due. In short, these are open-ended accounts that include things like credit cards and home equity lines of credit.
Installment debt, on the other hand, is debt you take on for a specific purpose and that has to be paid off in a fixed amount of time. Student loans, mortgages, and auto loans are all examples of installment accounts. Installment loans cannot be borrowed from regularly — which is why, for example, it’s easy to rack up such a large number of student loans. Every new quarter or semester requires another new loan since you can’t just add the new costs to the existing loan.
To know if your accounts are installment or revolving, you simply need to know if they’re loans (which are fixed) or if they’re lines of credit (from which you can repeatedly borrow). Your revolving accounts can stay open for basically as long as you use them (or longer, though some issuers close unused accounts after a period of time), and they start with a credit limit that can be increased or decreased by the issuer.
How Revolving Debt Affects Your Credit
If you care about tracking your credit, then it’s important to know the difference between your installment accounts and your revolving accounts. They both factor into your credit scores, but not in the same way.
Revolving accounts are used to measure what’s called your credit utilization ratio. That’s the balance on your revolving accounts compared to the total credit limits on your revolving accounts. Here’s how you can calculate it:
Add up the balances you owe on all of your revolving debt accounts — in other words, any credit cards or other lines of credit you have open
Add up the total credit limits of all those accounts
Divide the total balance by the total credit limit and multiply that by 100 — that’s your credit utilization ratio
Experts suggest keeping your total credit utilization below 30 percent. That means the less revolving debt you have, the better for your credit scores. Here’s a look at how the two major credit scoring companies factor in revolving debt.
FICO and Revolving Accounts
First of all, “Amounts owed” is the second most important factor of your FICO credit scores. That includes both your credit utilization ratio and the amount of installment debt you have.
So, why is this such an important factor in FICO scores? Here’s what their consumer website, myFICO, has to say about it:
“Your credit utilization ratio on revolving accounts — the percentage of your available credit you’re using — is an important factor in your FICO Scores. Using a high percentage of your available credit means you’re close to maxing out your credit cards, which can have a negative impact on your FICO Scores.”
VantageScore and Revolving Accounts
As for VantageScore, credit utilization gets its own line item separate from debt on installment accounts. What’s more, the revolving debt that makes up your credit utilization is more of a factor in your score. Credit utilization is considered a “highly influential” factor in VantageScore credit scores, while total debt is “moderately influential.”
The Best Way to Handle Revolving Accounts
What you can take away from this is that it’s better for your credit scores if you have a smaller credit utilization ratio — such as smaller outstanding balances on revolving debt. It’s also better for your long-term finances.
Revolving debt, like all debt, costs money to maintain. If you want to prevent that cost, you can pay your revolving accounts in full and on time every month. Any balance you carry over will compound with interest, and paying only the minimum due each month won’t make much of a dent in the overall balance.
In the end, the best way to handle revolving accounts for your credit is to use them when you need them, pay them off as soon as you’re able, and be careful not to use more than 30 percent of your available credit if you do have to carry a balance over from month to month.
This article originally appeared on UpturnCredit.com and was syndicated by MediaFeed.org.
Featured Image Credit: DepositPhotos.com.