Small business owners often face one major challenge—financing their business. And while there are many different ways to do so, one method is becoming more and more popular—revolving credit.
Revolving credit comes in different forms and is generally regarded as a smart way to finance a small business. These types of credit are a more flexible approach than traditional business loans. That’s the main reason it’s becoming an obvious choice among business owners.
Keep reading to find out everything you need to know about revolving credit—what it is, how it works, its pros and cons, and how to use it.
What is revolving credit?
Revolving credit is a type of loan that gives you access to a set amount of money. This type of loan is also known as a “revolving line of credit” or “revolving credit facility.”
How does revolving credit work?
Revolving credit works like a credit card. The borrower is allowed a fixed amount of credit to use. They have to pay off the credit, plus interest rates, by the end of a specified due date. The maximum amount of money you can borrow is called the credit limit.
When the borrower pays back this sum, their credit balance goes back to what it was in the beginning. Then, they can keep spending the same amount of money. The borrower can repeat this cycle as many times as needed, as long as they make timely payments. Revolving credit usually comes with an annual fee.
When you apply for a revolving credit loan, you qualify for a certain amount of money based on your credit score. This capital can be used for anything. You don’t necessarily need to spend the whole amount before the end of your cycle.
Revolving credit works like a credit card.
For instance, if you are approved for $50,000 and you only spent $10,000, you just need to pay off the $10,000 (along with interest). At the beginning of the next cycle, you will have $50,000 of available credit at your disposal.
The difference between revolving and non-revolving credit
Revolving and non-revolving credit both give you access to a certain amount of funds that you can withdraw and then pay off later with interest. The main difference lies in what happens after you complete this cycle.
As we’ve already explained, revolving lines of credit give you access to the same maximum amount of funds at the end of every billing cycle. They are an open-ended type of credit and can be used multiple times.
Non-revolving credit can only be used once. It doesn’t replenish after you’ve settled your balance. Your account will be closed and if you want access to more funds, you’ll need to apply for new credit.
One type of non-revolving credit is installment loans such as student loans, auto loans and personal loans.
Pros and cons of revolving credit
While there are many benefits of revolving credit, there are some downsides to it, as well. Before you decide if revolving credit would be a good choice for your business, you first need to look at the pros and cons.
Pros of revolving credit
- It’s flexible: One of the biggest benefits of revolving credit is its flexible nature. It gives you access to fast and affordable funding which you are free to use as you deem fit. You choose when and how to use it. You also choose the amount of credit you want to draw and for what purpose.
- You can use it repeatedly: As long as you honor your revolving credit agreement, you can use the funds repeatedly and as many times as you want. You don’t need to re-apply for a new loan every time you need money. Keep in mind that if you fall behind on your payments, your financial institution has the right to restrict your access to the funds.
- Interest is charged only on the amount you draw: You’ll only have to pay interest charges on the amount of money you draw and not the account’s full balance. This is a huge advantage over traditional loans which require you to pay interest on the entire lump sum.
- You can use it in many situations: There are a number of options for how to use this credit. It’s perfect for emergency situations as well as unexpected opportunities or purchases.
Revolving credit gives you access to fast and affordable funding.
Cons of revolving credit
- You can easily go into debt: If you use revolving credit to the spending limit, you could develop dangerous spending habits. For example, if you fail to pay off the balance at the end of the month, this will result in higher interest charges. These rates can even exceed 29%, which can make your credit card debt too difficult to pay off.
- You may harm your credit score: Even though responsible use of credit cards and loans generally helps improve your credit score, missed payments can easily put your accounts into default and thus harm your credit score. Keep in mind that a low credit score will most likely lead to high interest rates in the future. This will cripple you in situations when you have to borrow money again, so you may end up without getting a loan or a credit line.
- It may come with withdrawal requirements: Some revolving credit accounts come with pre-set withdrawal requirements. This means you as a borrower will need to withdraw a set amount of money before a particular date.
- There are various types of fees: The lender can charge an inactivity fee if you don’t use your credit for a defined amount of time.
How a revolving account affects your credit score
Revolving credit can have a great impact on your FICO credit score. However, how you handle that credit will determine whether that impact will be a positive or a negative one.
Here are a few ways a revolving credit can affect your credit score:
- Lowering your credit score: When you apply for revolving credit, your lender will need to perform a hard inquiry to see your credit report. Financial institutions perform a hard inquiry before they approve a loan, which means they do a detailed credit history revision. This could lower your credit score by a few points.
- Lowering the average age of your accounts: Age of credit history refers to the length of time you’ve been using credit. When you take out new credit, the average age of your accounts drops, which might lower your credit score.
The way you use your revolving account is another important factor that can influence your credit score. If you make your payments on time, even if it’s the minimum amount, your credit score will rise due to on-time payments.
If your payment history consists mostly of late payments, your credit score will drop.
Your credit line and the amount of credit you are using are also important factors. A lower credit utilization ratio can be beneficial for your credit. A credit utilization below 30% is ideal for credit cards.
4 tips for using revolving credit
This type of credit can be a very useful tool. Still, you need to know how to use your revolving accounts so that you keep a good credit score.
- Manage your cash flow: The best way to use your revolving credit is to withdraw money only for unforeseen expenses such as paying off debt or emergency expenses. Therefore, try to use it only when necessary.
- Plan ahead: Sometimes it’s more beneficial to use revolving credit as opposed to other types of loans. For instance, if you are remodeling your office, you can choose this type of business loan, especially if the project is expected to be long-term. This way, you will pay a lower amount of interest.
- Control your expenses: A large credit limit may be tempting, but it’s important to monitor your expenses. Keep in mind that a revolving credit doesn’t require you to spend the total credit limit. If you do, your total interest amount will probably be much higher and it will be harder to pay off your debt.
- Pay more than the minimum: You might want to settle just your minimum payment, but that could hurt you in the long run. You may end up having to pay off the account for a longer period of time and with more accumulated interest.
An alternative to revolving credit
Revolving credit has its benefits and drawbacks, just like any other loan. However, if you’re careful about how you manage your finances, it can greatly benefit your business.
On the other hand, if you would like to explore other options, we recommend looking into a merchant cash advance.
If you need a way to finance your small business, a merchant cash advance is a great alternative to revolving credit. This is not a typical loan, as it deducts a small percentage of your credit card receivables until you repay approved payback. You can use it to fund advertising campaigns, increase inventory, consolidate business debt or other purposes.
In the end, it all depends on your business needs and goals.
Whether you opt for revolving credit or an MCA, weigh their pros and cons to see what better fits your business.