When you borrow money through a loan, credit card or line of credit, how you repay the lender and accumulate interest charges can vary. One major factor that determines how the repayment process plays out is whether you have a revolving or installment form of credit on your hands. Not sure how these two types of credit work? Read on for a breakdown of revolving credit vs. installment credit.
What is installment credit?
Installment credit refers to loans you pay back in installments like personal loans and auto loans. With an installment loan, you will make fixed payments throughout the life of the loan on a consistent schedule (such as once a month).
Installment credit usually comes with a fixed interest rate, which means you will pay the exact same amount of interest until you pay off the loan in full. Because the interest rate doesn’t vary, your installment payment is consistent. You commonly use installment loans to cover major expenses like buying a home (if the interest rate is fixed, not variable) or a car.
The predictable nature of installment loans can make them much easier to budget for as you know exactly what each payment will be and when it is due.
Installment credit pros and cons
Before taking out an installment loan, it’s a good idea to consider the unique pros and cons of doing so.
Pros
- Predictable payments. Installment credit provides a clear and structured repayment plan and consistent payment amounts, making it easier for borrowers to budget and manage their finances.
- Large purchases become accessible. Installment credit can make it much easier for borrowers to afford significant purchases, such as homes or cars, as they don’t have to pay the full amount upfront.
Cons
- Less flexibility. If a borrower’s budget gets a little tight one month, they won’t have any flexibility on the amount they pay towards their loan.
- Collateral requirements. Some installment loans, like mortgages and auto loans, may require collateral, putting the borrower's property at risk if they fail to make payments.
What is revolving credit?
In contrast to installment credit, you don’t have to actually borrow any money when you have access to revolving credit. With revolving credit, the lender will issue you a credit limit and you can choose to borrow money until you hit that amount. As you make payments, you increase the amount you can borrow. Credit cards and home equity lines of credit are popular forms of revolving credit.
With revolving credit, you only pay interest on the money you borrow and typically make monthly payments based on the outstanding balance and any accrued interest. This process makes revolving credit a really flexible form of borrowing.
Revolving credit pros and cons
Similar to installment credit, revolving credit comes with its own set of advantages and disadvantages.
Pros
- Flexibility. With revolving credit, borrowers can choose to borrow the exact amount of money they need at any given time up to their credit limit. They will have immediate access to funds should they need them, but will also have the option to not borrow any money.
- No fixed repayment schedule. Unlike installment credit, borrowers have the freedom to make minimum or full payments with no fixed monthly obligation, offering greater flexibility when it comes to managing their finances.
Cons
- Accrued interest. Revolving credit often comes with higher interest rates than installment loans, and if users carry a balance, they can greatly add to the cost of their purchases.
- Debt accumulation. Because the interest rates on revolving credit are so high and borrowers can choose not to pay off their balance each month, they can watch their debt grow. As revolving credit debt mounts, it can be very difficult to pay it off.
How do revolving credit and installment credit affect your credit score?
How you manage any credit product can greatly impact your credit score in a good or bad way. To start, let’s look at the factors that can hurt or boost your credit score.
- Payment history: The most influential factor in credit scoring is your payment history. Making consistent on-time payments to any form of credit can help you improve your credit score.
- Credit mix: Lenders appreciate borrowers who have a diverse credit portfolio. Adding a new form of credit – whether it be revolving or installing – can bode well for your credit score.
- Credit history length: Installment loans and revolving credit both contribute to the length of a borrower's credit history. A longer credit history has a positive impact on credit scores.
- New credit: When you first apply for a new form of credit, doing so triggers a hard inquiry on your credit report, which will temporarily (but not significantly) hurt your credit score.
- Amount owed: If you have access to revolving credit, using too much of it can make your credit score drop. Try to keep your credit utilization ratio (aka how much of your available credit you’re using) below 30% to keep your credit score happy.
When should you get revolving credit?
Revolving credit gets a bad rap because it is commonly associated with credit cards, which come with notoriously high-interest rates. However, there are times when turning to revolving credit can make a lot of sense.
For example, if you are new to credit or have a limited credit history, obtaining a revolving credit account can help establish and build your credit profile. Responsible use, including timely payments and maintaining a low credit utilization rate, contributes positively to your credit history. With a credit card, you don’t pay interest if you pay off your balance in full by the end of the month, but can still enjoy the credit-boosting effects when you make your on-time payments.
A revolving form of credit like a HELOC can also serve as an emergency fund supplement.Revolving credit provides quick access to funds for unexpected expenses, offering a temporary solution while you work to secure other forms of funding.
When should you get installment credit?
Installment credit products can make a lot of sense when you are facing a major purchase like a car, house or home renovation project, all of which can improve the quality of your life or lead to enhanced financial stability. Most don’t have lump sums of cash to make such large purchases upfront, so paying a fixed amount of interest may very well be worth it. As an added bonus, if you make timely payments to installment loans, you can also see a credit score boost.
You may also be able to use certain forms of installment credit to help you pay off existing debt faster. If you have multiple high-interest debts, consolidating them into a single installment loan with a lower interest rate can simplify payments and potentially save you money on interest.
Frequently asked questions (FAQs)
Is it better to pay off revolving debt vs installment debt?
If you need to choose between focusing on paying off revolving debt or installment debt, paying off high-interest revolving debt first can help you save money. For long-term financial health, managing both responsibly is crucial, as installment debt, like mortgages, helps build credit. Ideally, you will make the minimum required payments on all forms of debt but will then make extra payments towards the debt with the highest interest rate.
What are examples of installment and revolving credit?
Common examples of installment credit include mortgages, auto loans and personal loans. Revolving credit is commonly seen in credit cards and lines of credit like HELOCs.
What is the difference between installment loan and credit sale?
With an installment loan, you will receive a lump sum and repay it in fixed installments. Credit sales occur when you buy goods or services on credit. When it comes to repaying a credit sale, you simply have to pay back the purchase amount in full by a certain timeline (typically 90 days) and can do so in a single payment or a series of smaller payments of your choosing.
This story was written by NJ Personal Finance, a partner of NJ.com. The information presented here is created independently from the NJ.com editorial staff, and purchases made through links in this article may result in NJ.com earning a commission.
