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Revolving credit vs. Installment credit: What you need to know
Credit can be a helpful tool when it comes to financing purchases. Borrowers use it to pay expenses with the promise that they will repay the lender.
We encounter credit in many ways throughout our financial lives. We use credit to purchase everyday items online, but also to finance large life-changing expenses such as a college degree or homeownership.
Because of its variety of uses, not all credit is made the same. Borrowing depends in part on the type of credit a lender extends to you. Installment credit and revolving credit are two of the major types of credit you may come across as a borrower. So, how do they stack up against each other?
What is installment credit?
When borrowers use installment credit, they’re taking out a loan for a specific lump sum of money over a set period of time. The borrower pays back the loan in regular intervals over a set repayment period, typically in monthly payments. In addition to paying back the amount of money that they borrowed, the borrower will also pay interest and fees on the loan. Interest rates will vary depending on a borrower’s creditworthiness and the type of installment loan.
One attribute that makes installment credit unique is that it has an end date. Once the loan has been paid off, the line of credit closes. Borrowers will need to reapply for new credit if they wish to borrow again.
Installment credit is useful for borrowers who need the total loan amount upfront and don’t have the cash on hand to make a large purchase.
Common types of installment loans include:
- Car loans
- Student loans
- Personal loans
What is revolving credit?
Unlike installment credit, revolving credit can stay open indefinitely. The borrower is given a specific credit limit and can spend up to the amount set forth by the lender. Revolving credit can be paid back and used as many times as the borrower needs as long as the borrower does not spend more than the credit limit that has been allotted.
The borrower is only required to make the minimum payment to keep the revolving credit account open. This may be expressed as a fixed amount or a percentage of the balance. Borrowers are then charged interest on the remaining amount they carry over.
Examples of revolving credit include:
- Credit cards
- Home equity line of credit
- Retail credit cards
Steady monthly payments
With installment loans, borrowers can usually count on consistent monthly payments. Having regular payments that cost the same and are due at the same time each month makes it easier for borrowers to create a monthly spending plan, as they won’t have to guess how much to budget for their loan payment.
Help pay for large purchases
For big-ticket items, installment credit gives borrowers the ability to spread out payments over time. Instead of saving for years to afford a house or car, you can obtain them through installment credit.
Cons of installment credit
Long loan terms
Because installment loans are meant to be paid off over time, it could take months or even years to fully pay off your debt. Homeowners and students are examples of borrowers with this type of debt. It’s common for mortgage loans to be offered in 15 and 30-year increments. For student loans, the average borrower pays back their debt in 20 years, according to the Education Data Initiative. If you’re taking out an installment loan, expect to be paying it off for a decent chunk of time.
Fixed loan amount
Borrowers are typically limited to the initial issuance amount of the installment loan. Translation: What you get is what you get. If you need more cash, you’ll have to apply for a new credit/loan.
Revolving credit makes everyday purchases easy. For example, with a credit card, you can buy essentials like groceries, gas, and online subscription services, or even pay a utility bill. Revolving credit services can also last for years, so borrowers don’t have to worry about applying for a new loan to use it more than once.
“Assuming you have room on your credit limit, you can run it up and pay it back down,” says Kate Mielitz, Ph.D., AFC. “You can use your card for literally anything.”
Opportunity to maintain a healthy credit utilization ratio
If you’re looking to show lenders you’re a responsible borrower, revolving credit is here to help. Your credit utilization refers to the amount of available credit you’re using. It makes up 30% of your credit score.
“One open credit card with a credit limit of $500 will have more impact on your credit score than your mortgage and auto loan put together,” says Timi Joy Jorgensen, Ph.D., assistant professor, and director of financial education and well-being at the American College of Financial Services.
Cons of revolving credit
It’s easy to make only the minimum payment on a credit card, but rolling over last month’s balance can cost you. After a credit card’s grace period is over, credit card interest can start accruing. Interest rates for credit cards can change monthly, weekly, or daily. Carrying high credit card balances can also drag down your FICO score (more on this later).
“It’s at a borrower’s discretion of how they pay off the balance,“ Jorgensen says. “If you pay the minimum, you could be paying off that plane ticket or those Christmas gifts for years.”
Temptation to overspend
With revolving credit, it’s up to you to determine how much you want to spend every month, and it’s easy to go overboard. A person’s credit card limit increases rapidly between their 20s and 40s. The average credit card limit increased by more than 700% during this time, according to research published by the West Virginia University Department of Economics (see page 11).
People without a spending plan in place may blow past their limit and spend more than they anticipated.
Carrying a balance on a credit card can severely impact your score. Lenders view borrowers with high amounts of credit card debt as risky. How much you owe on your credit card in comparison to the amount of available credit you have available is known as your credit utilization ratio. Most financial professionals advise consumers to keep their credit utilization ratio at 30% or below.
“The impact of your credit score really comes down to amounts owed, which has nothing to do with installment credit and everything to do with revolving credit,” Mielitz says.
When used responsibly, revolving credit can have a positive effect on your credit score. Because revolving credit is long-term, borrowers can create an extensive credit history over time. The longer the revolving credit has been open and in good standing, the bigger the impact it’ll have on your credit report.
“Revolving credit gives a lender a better view of a borrower’s trends and behaviors than installment credit,” Jorgensen says. “It lets them look at how financially savvy you are and how you navigate credit.”
When a borrower pays back installment credit on time and abides by the terms of the loan, it can have a positive effect on their credit score. To reap the benefits, you’ll want to make sure the lender reports your payment history to one of the three major credit bureaus.
Making on-time payments will be the most important factor when it comes to its impact on your credit score. If borrowers pay the loan on time as agreed upon, installment credit can produce positive credit history, but with limitations.
“Installment credit doesn’t really show lenders how you behave as a consumer,” Jorgensen says. “You either pay the loan back or you don’t.”
Compared to revolving credit, it also doesn’t give consumers as much control over their credit score. For example, a borrower with bad credit could see their score jump up quickly if they paid off all their credit card debt. The next time a financial institution calculates the score, borrowers would see an impact. With installment credit, borrowers may have to wait until they’ve built up enough positive credit history to see the benefit to their score.
In general, when it comes to paying off debt, borrowers should review each debt obligation to determine which one is costing them more. While paying off revolving credit and installment credit simultaneously would be ideal, sometimes an individual’s financial circumstances don’t allow it.
A crucial consideration when determining which debt to prioritize is whether it’s tied to an asset, such as a mortgage. Installment credit is often linked to something tangible. Most people need a car to drive to work and a roof over their heads. The threat of repossession, foreclosure, or eviction can help keep borrowers on track when it comes to making ends meet. A foreclosure can stay on your credit report for seven years, and an eviction can stay on your housing record for seven years, which can prevent you from accessing housing in the future.
“A credit card turned over to collections can stay on your report for seven years, but at least you didn’t lose your health and safety and still have a place to live,” Mielitz says.
Revolving credit is often used to pay for smaller purchases—the late-night online impulse buy, the pizza takeout, and the new vacuum. Because a credit card issuer can’t repossess these items, it’s easier for them to be pushed out of the front of your mind. You may even forget you bought them until you look at your monthly credit card statement.
The Bottom Line
Installment credit and revolving credit can both be useful tools to borrowers when used appropriately. With on-time payments, credit accounts can help you build a strong and diversified credit history.