When you have a line of credit, there are two types of
repayment structure:
revolving credit
and
installment credit. Both forms of credit are
secured
or
unsecured. A secured installment loan is more common.
Revolving Credit: Your lender advances a
set
credit limit
that you use all at once or in part. You borrow the money,
spend it, repay it, and spend it again with revolving
credit.
Installment Credit: Your lender advances
the total amount, and you repay it with scheduled, periodic
payments. You gradually reduce the principal, which leads to
paying off the original amount.
What Is Revolving Credit?
A
line of credit (LOC)
or credit card is the most common revolving credit form.
When you make payments on this credit line, your credit
limit does not change. You can borrow from it as much as you
want if you do not exceed the original limit. There isn't a
set payment plan because you are not borrowing a lump sum.
You can borrow up to your credit limit. You'll pay more for
this flexibility, higher interest rates, and possibly a
lower borrowing amount. You'll only be charged for the
amount you withdraw every month, not the entire credit
limit.
What Is Installment Credit?
A car loan or mortgage is the most common form of this type.
Installment credit is an account with a predetermined
length, and closing date, often called the loan term. You know the amount of your monthly payments and how long
you need to make those payments. If you need to borrow more
money, you'll fill out another application.
Examples of Revolving Credit and Installment Credit
Advantages of Revolving Credit
A revolving line of credit has pros and cons that need to be
considered. Here's how it stacks up against installment
credit.
Flexible Borrowing
You get the maximum amount available whenever you need it.
Even if you don't need it right now, you'll have a piece of
mind. There's no need to go through a lengthy approval
process if you need extra cash. You use what you need at the
time.
Covers Financial Rough Spots
Even if you have a good credit score, your cash flow can be
uneven. Suppose you are a salesperson who sells cars and
only makes money from a handful of sales a year. A line of
credit will help you keep current on your financial
obligations during the months when your cash flow is low.
You also might make most of your money during the last
fiscal quarter if you own a seasonal business. Your
revolving credit line will allow you to hire needed staff,
knowing that you'll meet the added costs later.
Secure Financing Option
If you need a lower interest rate, you could apply for a
secured line of credit option. You can use types of
collateral to secure your revolving credit. Here are some
examples:
Repayment Flexibility
You'll have the flexibility to decide how and when your
credit line is repaid. Citing the example of the seasonal
business, after your busy season, you have plenty of cash on
hand. You can postpone repayment until your cash flow
supports it.
Disadvantages of Revolving Line of Credit
Higher Interest Rates
Because revolving lines of credit are flexible, lenders
consider them to carry more risk. Because of this, you'll
likely encounter higher interest rates than installment
credit. If you're looking to make a large purchase,
consider an installment loan
instead.
Temptation
Americans overspend when they have revolving credit. Check
out these
credit card debt stats. There is also a tendency to pay the minimum amount every
month because it is so small, spending a considerable amount
on interest over time.
Lower Credit Limits
As mentioned above, revolving credit is considered higher
risk leading lenders to approve you for lower credit limits.
If you need substantial financing, this line of credit
option is not for you.
Unexpected Adjustable Terms
The terms of use for revolving lines of credit, including
your interest rate, can change with little notice. You won't
have to accept any new terms, but any new terms legally bind
you if you continue to use that credit. Unfortunately, your
only option to not accept those new terms is to pay your
full balance and cancel that credit line.
Advantages of Installment Credit
Installment credit has pros and cons
that you need to consider. Here's how it stacks up against a
revolving line of credit.
Predictable Payments
Monthly payments set at the same amount provide
predictability for your budget. Compared to revolving
credit, Installment credit has a fixed term, interest rate,
and in most cases, the same monthly payment.
Larger Loan Limits
Because lenders consider this type of credit less risky,
you'll be able to access higher loan limits than with
revolving credit if you can meet the requirements. Of
course, it doesn't mean that you won't be able to apply for
a smaller loan amount. You can get a loan for a few thousand
dollars if that's all you need.
Lower Borrowing Costs
In terms of interest rates, installment credit can be less
expensive. Lenders offer lower interest rates which will
cost less over time. Some people use installment credit to
pay off their revolving credit when the interest rate is
lower.
Make Large Purchases
One of the common features of installment credit is its
versatility. Once approved, you can use it to pay for a
major purchase, such as a car. You can also use it to
purchase a home and pay later in small amounts for 15 to 30
years.
Disadvantages of Installment Credit
Tough To Qualify
Because of the lower interest rates, lenders have more
stringent requirements for you to qualify. They will
consider your income, credit history, and other outstanding
debt. Most revolving credit lines tend to be more lenient in
their lending practices, particularly for higher-risk
borrowers.
Prepayment Penalties
Some lending agreements will not allow you to pay off your
credit line early, so you must read the fine print. You can
be charged a substantial fee for paying more than the
required amount each month or settle the debt entirely.
Double Dipping
As mentioned before, you can use installment credit to pay
off your revolving credit if you find a lower interest rate.
But, you have to commit not to use your revolving credit.
Running up new balances and the monthly payments required by
your installment credit will put additional pressure on your
budget.
Locked Terms
Because the terms of your installment credit are determined
before you close, you will not be able to renegotiate. The
payment schedule, interest rate, and terms are set in stone.
If your financial situation changes or your credit improves,
you will have to refinance to get a better interest rate.
How Can You Build Credit With Installment and Revolving
Credit?
How you
use lines of credit
can certainly hurt your credit score if it is not used
wisely, but it can be great for your score if you manage
both your credit mix and your credit utilization. Follow
these tips to improve and
build your credit fast.
Don't spend it all at once: How you manage
your credit balance is a significant portion of your
credit score. Your credit utilization ratio, how much you owe compared
to your credit balance, is 30% of your FICO score. Keep your
ratio below one-third of your limit, and your credit will
improve.
Pay bills on time: Make all your monthly
payments on time because your payment history is the biggest
factor in your credit score. If you miss any payments, your
score will reduce significantly.
Use different types of credit: Lenders feel
more confident if you show them that you can manage
different kinds of credit. Having both installment and
revolving credit will benefit your credit score.
Do not open too many accounts at once:
Having different credit types is a benefit, but you do not
want to open all of them at once. Be careful not to open too
many accounts within a few months or even a year. The best
strategy is to build credit steadily over time.
Continue using your credit: Your score will
increase if you use credit over an extended period.
Make Educated Decisions About Your Credit
Knowing the difference between revolving and installment
credit allows you to make better financial decisions. Many
borrowing options are available, whether your goal is to
save money on interest, get through tough times, build your
credit, or pay off your debt. But, before you apply for any
credit, keep in mind how it will affect you. Doing so will
allow you to manage your finances and set you up for
success.