There are two fundamental types of credit repayments: revolving credit and installment credit. Installment credit is paid back with scheduled, periodic payments; installment loans involve the gradual reduction of principal and eventual full repayment, ending the credit cycle. In contrast, revolving credit contracts, in which the payments are open-ended, and any funds repaid are available to be borrowed again.
Both installment loans and revolving loans come in secured and unsecured forms, but it is more common to see secured installment loans. Any type of loan can conceivably be made through either an installment credit account or a revolving credit account, but not both.
Perhaps the most distinguishing features of an installment credit account are a predetermined length and an end date, which is sometimes referred to as the term of the loan. The loan agreement usually includes an amortization schedule, in which the principal is gradually reduced through installment payments over the course of several years.
Common installment loans include mortgages, auto loans, student loans and private personal loans. With each of these loans, you generally know how much your monthly payment is and how long you will be making payments. An additional credit application is required to borrow more money.
Installment credit is considered to be less dangerous to your credit score than revolving credit.
Credit cards and lines of credit are two familiar forms of revolving credit. Your credit limit does not change when you make payments on your revolving credit account. You can return to your account to borrow additional money as often as you want, as long as you do not exceed your maximum.
Because you are not borrowing a lump sum when the account is opened, there is no set payment plan with revolving credit. You are merely being granted the ability to borrow up to a certain amount. However, this flexibility often results in lower borrowing amounts and higher interest rates. Unsecured revolving credit account interest rates often range around 15%–20% or more. The interest rate is rarely locked in, and creditors have the right to increase your rate if you fail to make payments.
Revolving credit is considered a more dangerous way to borrow than installment credit. An enormous part of your credit score (30%, according to Experian) is your credit utilization rate (that is, how closely your card balance is to your overall limit on each card). Carrying high balances drags down your score.
Installment Credit to Pay Revolving Credit
Although it has some benefits (see "What Is the Use of Having Revolving Credit If Your Credit Score Suffers for Using It?") revolving credit can quickly become a financial burden. Some people even take out installment loans to pay off their revolving credit. There are both advantages and disadvantages to this strategy.
The greatest benefit of using installment credit to pay down revolving debt is the adjustment in monthly repayment expectations. With credit cards and other revolving debt, you are expected to pay a minimum amount on each outstanding balance. This can create numerous required payments with a wide range of repayment amounts, causing some difficulty in budgeting from month to month.
With installment credit, you are provided a set monthly repayment amount for a stated period of time, making budgeting far easier. Installment loans can also be extended over time, allowing for lower monthly payments that may align better with your cash flow needs each month.
Lower Cost of Borrowing
For qualified borrowers, installment credit can be less expensive than revolving credit as it relates to interest rates and user fees. Credit card companies charge interest rates that range from 9% to 25%, which compounds each month when balances are not paid in full. The higher the interest rate, the more expensive carrying revolving debt can be over the long term.
Conversely, installment credit lenders offer lower interest rates, ranging from 2% for secured loans to 18% for unsecured notes. Utilizing the lower interest rate charged for installment credit to pay down revolving debt can mean hundreds to thousands of dollars in savings over the course of the repayment term. Also, revolving debt can come with excessive fees for late payments, exceeding credit limits or annual maintenance; installment credit is void of these charges.
Disadvantages to Installment Credit
Although you can reap some benefits from using installment credit to pay off more expensive, variable revolving debt, some drawbacks exist. First, some installment credit lenders do not allow you to prepay the loan balance. This means that you aren't allowed to pay more than the required amount each month (or even settle the debt entirely) without being assessed a prepayment penalty. This is typically not an issue with credit card debt repayment.
Installment credit lenders require more stringent qualifications as it pertains to income, other outstanding debt and credit history. Most credit card companies are more lenient in their lending practices, particularly for higher-risk borrowers.
Installment credit may seem to be a cure-all to high interest rate revolving debt, but this strategy is only beneficial if you are committed to purchasing much with credit cards once you pay off the balances. Running up new credit card balances in addition to the monthly payments required by an installment loan can put incredible pressure on your budget each month.