How a Revolving Line of Credit Works

Need regular credit for your business, but don’t want to open up your enterprise to the risk of being rejected for a loan right before you need to make a payment on a new piece of property or equipment? Many business owners run into this problem, so they take out revolving lines of credit instead of relying on traditional one-time loans. However, revolving lines of credit are even more common than you might think. Many people use credit cards, which are types of revolving credit for personal expenditures. Regular folks can use this revolving credit to make big purchases frequently. Still unsure how exactly revolving lines of credit work or whether they’re a good idea for your business? This page will break down everything you need to know about revolving credit.

What is Revolving Credit? 

“Revolving” credit is a type of credit that you can continue to take out over and over without having to reapply for that line of credit more than once. A normal loan works like this:

1. You apply for a loan or line of credit, and the lender decides to give you the loan or not based on things like your credit history, your income, and more
2. If you are approved for the line of credit or loan, you can then spend that credit up until a predetermined amount
3. You must then pay back the credit in its entirety by a certain timeframe. Once the loan is paid back, the contract closes, and you no longer have that credit to draw on for financing your business or paying for other things

In contrast, a revolving line of credit is drawn from a revolving credit account. With these accounts, the credit line is left open until one or both parties decide to close the account. For example:

1. You decide to apply for a credit card with a credit limit of $500
2. You are approved for the credit card and use the card to purchase $200 worth of supplies for your business
3. You then need to pay back the $200 at a rate of a minimum payment amount, such as $25 per month plus interest, either indefinitely or until the credit line is cleared
4. However, say that you pay down $100 of the $200 in credit you have taken out. Once you pay back that $100 of credit, your available credit line goes from $300-$400

In other words, a credit card is an example of a revolving line of credit since you can continue to use the credit so long as you have paid off enough of the credit line beforehand. With any revolving line of credit, the credit line overall continues to remain open provided that the borrower does not go over the credit limit and keeps the account in good standing.  For an account to stay in good standing, the borrower must:

• Pay at least some of the balance off on time and at a regular cadence
• Pay the interest amount
• Not overdraw the account
• And any other requirements that may be specified by the revolving line of credit contract

Is Revolving Credit the Same as a Credit Line?

No, but revolving credit is a type of credit line.  Revolving credit is used by businesses who need financial flexibility when purchasing supplies or equipment for their enterprises and who don’t have the time to reapply for new loans with set limits or timeframes continuously. By taking out a revolving line of credit , businesses can continue to draw on credit to make expensive purchases and gradually pay down the balance as needed. The revolving line of credit means they always have at least some extra means of paying for what they need to stay in business at any moment’s notice.

How is Interest Calculated for Revolving Credit? 

A revolving line of credit accrues interest over time, even though it doesn't have a set endpoint. Lenders use interest rates in order to make money on the loans they give out. But the interest for revolving credit lines is usually calculated slightly differently than the interest calculator for a set or static loans. With a revolving line of credit, interest is only paid based on the principal balance amount. For example, if you have a $500 credit card, interest isn’t paid on the hypothetical $500 maximum line of credit taken out. Instead, interest is paid on however much of that maximum amount you use for your purchases. Here’s a more detailed breakdown:

• Interest is calculated by first determining the principal balance amount. The principal balance is whatever amount is outstanding for the prior month or billing cycle
• For example, say that you have a revolving business line of credit for $10,000. You don’t spend any of it for the first five days, so your balance is $0
• Then you borrow all $10,000 the next day
• You pay back $5000 toward the principal four days later. By this point, 21 days are remaining in the month
• Because of this, your interest payment is calculated on the interest for $10,000 for the first five days PLUS the interest for $5000 for the remaining 21 days of the month

It can certainly get a little complex, which is why most credit statements have detailed mathematical breakdowns of the interest calculations for you to look over each time you get your bill. With most businesses revolving lines of credit, interest is calculated based on actual days with a balance taken out over a 360 day year. For example, a revolving credit line for a business may use an equation like this:

• Interest on the revolving line of credit = (balance x interest rate x number of days in a month) / 360

You can also use revolving credit calculators to make it easier for yourself.

Detailed Example of Revolving Interest

Say that you have a principal balance of $10,000 from June 1 to June 15. The credit’s interest rate is 40%. You can plug these values into the above equation. If you multiply 10,000 x 0.4, then multiply by 15 (the number of days in June on which you had a principal balance of $10,000). Then you divide that amount by 360. The resulting interest would be $166.67. 

Benefits of Revolving Credit

There are lots of benefits that revolving credit brings to businesses. For example, revolving credit means that a business theoretically always has a little extra credit to spend in an emergency. With a revolving credit line of up to $10,000, a business owner can make an instantaneous purchase to replace a car, refrigerator, or other important equipment for their business whenever they need it without having to apply for a loan. Furthermore, revolving credit is excellent for building a business credit score over time. If you use revolving credit regularly and pay it off on time without incurring any late fees or penalties, your business credit score will skyrocket in a matter of months. Plus, not having to take out regular one-time loans over and over means that your credit score will not be checked again and again. Hard inquiries into your credit score can make it drop by some number of points, which can really add up over time.

Is a Revolving Line of Credit a Good Idea?

Still, revolving credit can be risky if you don’t practice good debt management strategies and don’t have a plan to pay back the revolving credit on time. Revolving credit can trap some business owners, who use the credit frivolously and let the balance become too much such that interest eventually catches up with them. With revolving credit, it's usually a good idea to keep the principal balance low if possible, as interest compounds with time. It becomes quite expensive if you are near the cap of your revolving credit line. Even with this risk, a revolving line of credit could be a great idea for your business if you need the versatility and flexibility it provides.

Summary

Ultimately, revolving credit is just one more financial tool for business owners that can and should leverage to ensure they always have the financial wiggle room needed to keep operating. When used correctly, revolving credit can be more flexible and beneficial than one-time loans. But they can also be used incorrectly or lead to financial problems if you don’t pay them off properly. Need help mastering financial management strategies, or interested in ways you can secure business credit for your organization? Contact Seek Capital today and let our financial experts help! Sources: Credit Karma Guide to Business Credit Scores | Credit Karma What Is Revolving Credit? | Experian Payment Calculator for Credit Cards and Other Revolving Credit Loans | Dallasfed.org