If you have a mortgage or a car loan, you have closed-end credit. It's a type of loan with a fixed amount of funds that you generally use for a specific purpose. You'll need to pay the loan with interest in a particular repayment schedule. Once you pay off the loan, your account will be closed.
How Closed-End Credit Works
You and your lender agree to the amount you need to borrow, the monthly payment, and the interest rate. These factors are dependent on your credit rating. Getting closed-end credit is an excellent way to build your credit by demonstrating to lenders that you can borrow responsibly.
You can use close-end credit if you're looking to make an expensive purchase and pay for it over time.
Many lending institutions define closed-end credit as secured loans or installment loans. Online lenders, credit unions, and banks offer a closed-end lending option.
As mentioned before, auto loans and real estate are examples of closed-end credit. Sometimes referred to as revolving credit lines, credit cards and home equity lines of credit (HELOC) are open-end credit. The main difference between open-credit and closed-end credit is the debt and how you repay it.
Closed-end credit is issued to you for a particular purpose and must be paid within a set period. At the end of the agreed term, you must pay the entire balance, including interest and any maintenance fees. Closed-end credit does not offer any available credit or revolve, and you cannot modify the terms.
The monthly payments and interest rate are fixed. However, the interest rates can vary between lenders. Closed-end credit interest rates are generally lower than open-end credit. The interest accrues every day on your outstanding balance. Most closed-end credit loans have fixed interest rates; a mortgage loan can offer a fixed or variable rate.
If you're looking to be approved for closed-end credit, you need to inform the lender of the purpose of the loan. You also may be asked to have a down payment.
Secured vs. Unsecured Closed-End Credit Accounts
Closed-end credit can be either unsecured or secured. Unsecured closed-end credit does not require collateral if you meet the lender's credit requirements and agree to repay the loan on time with interest. Because no collateral is needed, your credit score will need to be at least in good standing for you to qualify.
On the other hand, secured closed-end credit requires you to use collateral that the lender could possess if you default on your loan terms. You may opt to use collateral because you'd need a higher loan amount, or your credit score doesn't allow you to be approved for unsecured closed-end credit. Using secured closed-end credit can improve your chances to be approved, lower your interest rate, and increase your borrowing amount.
Common Examples of Closed-End Credit
Smartphone Financing
You can find smartphone financing at retail stores that sell cellphones or through cellphone service providers. Most providers allow you to pay off your devices in installments with no interest or finance charges. You'll most likely need a two-year contract to take advantage of this benefit, and an upgrade fee also applies.
If you're not going to switch to another cellphone company any time soon, then this option is for you. If you decide to break your contract, you could be required to pay a fee - Or pay off the balance that you owe.
In-Store Financing
Furniture stores and online retailers offer closed-end credit. You can walk into a store or apply online by filling out a quick application. Once you're approved, you'll have a fixed interest rate with weekly, monthly, or bimonthly payments. You'll get your furniture delivered, and you make payments until your furniture, computer, appliance, or mattress is paid off with interest.
Car Loans
Using closed-end credit to make larger purchases is why you would get a car loan. Auto lenders check if your income can afford the monthly payments, your employment history if you've had a previous car loan, your credit scores, and your history.
Your interest rate will depend on your credit score, the loan length, the size of your down payment, and the vehicle you choose. If you have a loan and make your payments on time and your credit score rises, you could refinance your car loan to get smaller payments and get a better rate.
Education Loans
Paying for your education is another example of closed-end credit. If you apply for financial aid, be sure to understand where you get the loan from and the terms and conditions. Student loans can come from banks, financial institutions, or the federal government. Federal Student Loans sometimes have better benefits than loans from private sources and banks.
Mortgage
A mortgage loan is probably the most extensive closed-end credit account you can acquire. You sign an agreement with a mortgage lender to lend you the money to buy a home because you don't have the cash upfront. This agreement gives your lender legal rights to repossess your property if you fail to meet the requirements and terms of your mortgage. The process of failing to make payments and forfeiting your property to your lender is called foreclosure.
Closed-End Credit Pros
Predictability
The positive side of closed-end credit is it offers predictability and stability. With no annual fees and a fixed interest rate and term, you know how much your payment will be each month and can budget accordingly. And when you've finished paying it off, that debt is done with. These forms of credit are typically more straightforward and with fewer fees.
Money All At Once
A closed-end loan gives the borrower the entire loan amount upfront and requires them to pay it back over time in installments.
Significant Purchases
Ideal for making a big-ticket purchase, you can get a car, furniture, or a house using closed-end credit.
Lower Interest Rate
Closed-end credit usually has a lower interest rate than open-end credit. However, interest is charged on the entire principal amount.
Closed-End Credit Cons
Not Flexible
Closed-end credit is not very flexible. You have to determine how much funding you need before receiving it. You'll need to refinance (at a cost) if you decide later that you need more money. It's best to use this type of credit if you make a large, single, predictable purchase. If you have issues budgeting and making payment commitments - This type of loan is not for you.
Maturity Date
Closed-end credit has a maturity date, at which time the debt must be paid in full or refinanced. If you don't have funds to pay at that time and don't qualify to refinance, you're in trouble.
How to Get Approved for Closed-End Credit
You can apply online for closed-end credit from an alternative lender, bank, cellphone provider, car dealership, department store, or credit union. Generally, you'll need to use the money you've borrowed for a specific purpose. For instance, A personal loan is a type of closed-end credit you can use however you like. A car loan, by comparison, is a closed-end credit that must be used to purchase a vehicle.
Your lender will check your credit history before you're approved. If your credit score is on the lower end, you may have to make a down payment. Your credit score will impact the interest rate you pay and the amount you can borrow.
Payment Terms on Closed-End Credit
Whenever you borrow money, you pay interest. The interest rate is typically fixed on your entire closed-end credit term. Although with certain mortgages, you could have a variable interest rate.
Closed-end credit is a better long-term borrowing option than open-end credit because it has a lower rate. You pay less overall with a lower interest rate.
Conversely, your monthly payment for closed-end credit is generally higher than open-end credit, even for the same amount. Because you have a fixed payment to make every month, you don't have the flexibility to make a lower payment if you need.
If you make a late payment, your lender charges a late fee. Your lender will report to the credit bureaus if your payment is more than 30 days late. Depending on the terms, you could be considered default if your account becomes 30 to 90 days past due. At that point, you lose the option to make monthly payments because your lender will require the entire balance you owe.
How Closed-End Credit Affects Your Credit
10% of your FICO credit score depends on your credit mix. The more types of credit you have are considered much better than having a kind of credit. If you already have a credit card (open-end credit) and get approved for a personal loan (closed-end credit), you will help your credit score.
Closed-end credit affects your credit score the same way as other credit accounts. If your creditor reports your late payments, your score will drop. On the flip side, your on-time payments will help boost your score.
While you pay your account, your creditor sends monthly updates on your account status to the credit bureaus. Once you finish paying, your account closes and stays on your credit report for another ten years or more. Any unfavorable information associated with your account will fall off your credit report in seven years.
Is Closed-End Credit Right For You?
When you borrow any money, you need to consider that you can afford new debt honestly. If you are still unsure if closed-end credit is suitable for you, these points should help you decide.
- If you only need to borrow once and repay the funds over time, a closed-end credit is right for you.
- Your payments are based on your credit rating, and if your credit is good, you may qualify for a lower interest rate and save money over time.
- If you want to build your credit, obtaining closed-end credit will build your score if you make on-time payments.
- Use closed-end credit if you need to purchase an expensive item like a vehicle, house, furniture, and more.