Revolving Credit vs. Installment Credit: An Overview
There are two fundamental types of credit repayments: revolving credit and installment credit. Revolving credit allows borrowers to spend the borrowed money, repay it, and spend it again. The lender advances them a set credit limit that can be used all at once or in part.
In contrast, borrowers repay installment credit loans with scheduled, periodic payments. This type of credit involves the gradual reduction of principal and eventual full repayment, ending the credit cycle.
- Installment credit gives borrowers a lump sum, and fixed, scheduled payments are made until the loan is paid in full.
- Revolving credit allows a borrower to spend the money they have borrowed, repay it, and borrow again as needed.
- Credit cards and credit lines are examples of revolving credit.
- Examples of installment loans include mortgages, auto loans, student loans, and personal loans.
What Is Revolving Credit?
A credit card and a line of credit (LOC) are two common 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 more money as often as you want, as long as you do not exceed your limit.
Because you are not borrowing a lump sum when the account is opened, there is no set payment plan with revolving credit. You are granted the ability to borrow up to a certain amount. However, this flexibility often results in lower borrowing amounts and higher interest rates. Borrowers owe interest on the amount they draw, not on the entire credit limit.
Revolving credit can be a more dangerous way to borrow than installment credit. A big part of your credit score (30%) is your credit utilization ratio—for example, how close your card card balance is to your overall limit on each card. Carrying high balances drags down your score.
What Is Installment Credit?
The most distinguishing features of an installment credit account are the predetermined length and end date, often 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 personal loans. With each of these, you know how much your monthly payment is and how long you will make payments. An additional credit application is required to borrow more money.
|Revolving Credit vs. Installment Credit|
|Revolving Credit||Installment Credit|
Amount loaned can be used at any time, paid back, and borrowed again as needed
|Borrowers have access to the amount loaned in one lump sum|
|Has higher interest rates||Can be tougher to qualify for|
|Borrowers only owe interest on the amount they draw||Fixed number of payments, including interest, over a set period of time|
Pros and Cons of Installment Credit
Installment credit has pros and cons that need to be considered. Here’s how it stacks up against revolving credit.
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 the outstanding balance. This can create numerous required payments with a wide range of repayment amounts, causing difficulty in budgeting.
With installment credit, you are provided a set monthly repayment amount for a stated period of time, making budgeting easier. Installment loans also can be extended over time—a 30-year mortgage is one example—allowing for lower monthly payments that may align better with your monthly cash flow needs.
Lower borrowing costs
For qualified borrowers, installment credit can be less expensive than revolving credit as it relates to interest rates. Credit card companies charge interest rates that compound each month when balances are not fully paid. The higher the interest rate, the more expensive it can be to carry revolving debt over the long term.
In general, installment credit lenders offer lower interest rates for borrowers who have good credit. Some people even take out installment loans to pay off their revolving credit. There are advantages and disadvantages to this strategy. Also, revolving debt can come with excessive fees for late payments or exceeding credit limits.
Disadvantages of installment credit
Although there are some benefits to using installment credit to pay off more expensive, revolving debt, some drawbacks exist. First, some lenders do not allow you to prepay the loan balance. This means that you are not 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 have more stringent qualifications regarding 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 a cure-all to high-interest-rate revolving debt, but this strategy is only beneficial if you are committed to purchasing much less 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.
Experian. “What is a Credit Utilization Ratio?"