When it comes to different types of large purchases or financing our big life dreams, a line of credit or loan can be helpful. It’s rare that people can pay for things like a house or car in full, so borrowing money or using credit is something that almost everyone does at some point. That means that when you need to borrow money, deciding between installment loans vs revolving credit is a big decision.
The two major forms of lending accounts—Installment loans and revolving credit—do have some similarities. Both types of debt will impact your credit score and have some form of interest (fixed or varied) attached to them. Additionally, both installment loans and revolving credit can be backed by collateral (secured) or only issued based on your credit score and debt history (unsecured).
But each option has conditions that, when applied to a person’s specific lifestyle and financial goals, will not only address their current needs but will also have a lasting effect that will impact their credit score. Exactly how it will impact you depends heavily on your choice.
But, what is the best choice?
When it comes to choosing between the lending options available to you, it’s important to carefully consider the options. Let’s take a look at how installment loans and revolving credit work, and how understanding their advantages and disadvantages will affect your financial future.
What Is an Installment Loan?
An installment loan is a loan that is repaid through a series of scheduled payments of a predetermined amount. Each payment includes a portion of the total amount borrowed (principal) and the interest charged by the financial institution that issued the loan. These loans are generally paid back in monthly installments. Virtually all installment loans have a fixed interest rate.
These loans provide borrowers with lump sums of money they can use for large purchases. Many of the types of loans that we are familiar with fall into the category of installment loans. Some examples include:
Auto loans are used to purchase cars. They’re low risk because they are secured by the car. But that means that if you don’t make your payments the lender can take your car away. These missed payments can also impact your credit score.
A mortgage is a loan used to purchase a home. These loans are also low risk because they are secured by the house. Just remember to make your payments so you can keep the house.
These loans are used to cover a host of expenses, from medical bills to home and car repairs. Personal loans can be either secured with collateral or unsecured for borrowers with strong credit history.
Federal Student Loans
These loans fund college tuition and expenses. Requiring no collateral, student loans issued by the government are unsecured.
With its structured repayment schedule, an installment loan can help a borrower establish, and even rebuild credit. As the amount of money owed each month doesn’t change in an installment loan agreement, borrowers are able to effectively plan for those payments. And, making consistent payments on installment accounts that meet due dates will positively affect the most important factor in determining your credit score: your payment history. Make steady payments, and your total credit score will almost certainly increase over time.
While this repayment schedule is set and predictable, it commits the borrower to spend a fixed amount of time in debt. While it is possible to pay off an installment plan early, it doesn’t necessarily do anything to raise or lower your credit score. In some cases, paying off your loan early can make you accrue a fee called a prepayment penalty. Your loan agreement is a contract, and this penalty is the consequence of breaking that contract.
While installment loans can provide you with money when you need it, however, it’s advised to carefully consider the effects of carrying debt long-term will have on your life.
What Is Revolving Credit?
Unlike an installment loan that delivers a lump sum cash payment upfront, revolving credit gives you a credit limit that you are able to use as you see fit. Your credit limit remains the same, regardless of any monthly payments, and you are only required to pay back the amount of the credit line that you use.
For example, if you spend $500 on a $1000 credit line, you are only responsible for repaying that $500. If that same $500 were to be repaid in full before the next billing cycle, you would again have access to the full line of credit.
However, if you don’t pay the balance off in full at the end of the billing cycle, it carries over—or “revolves”—to the next cycle. When a balance revolves, you will have to make some form of minimum payment – either a fixed amount or a percentage of the remaining balance, whichever is larger. And with this credit revolving, interest will be charged on the balance.
Examples of revolving credit include:
Your credit card is issued by banks or other financial institutions. Many credit cards also offer the option of cash advances, which can usually be pulled from an ATM. Credit cards – particularly those with a 0% APR – are also used for balance transfers that move debt from one account to another in an effort to save money on interest charges.
Since credit card debt is unsecured debt that isn’t backed by anything, the interest rates tend to vary over time. Your overall credit card usage is one of the factors affecting your credit score. Credit card debt is a big issue for many Americans. Your credit card debt also contributes to your overall debt load. So make sure to do plenty of research before getting a new credit card.
Store credit cards
This is a credit card issued by retailers for purchases in their stores or on their websites. Because these credit cards typically carry high interest rates, the value of the card should be worth it, so an ideal store credit card is one from a location that you patronize often.
Home equity lines of credit (HELOC)
Similar to a home equity loan, a HELOC converts equity but instead gives the borrower credit instead of cash. Most people who get a HELOC use it for home improvements, business purchases, and emergency expenses. Since a HELOC is secured debt that uses your home as collateral, banks are more likely to offer low, fixed interest rates.
Revolving Credit Cautions
While revolving credit is accessible, it can become a huge financial burden if it isn’t properly managed. Revolving lines of credit have additional expenses, like annual fees and overdraft penalties, that can pile up on top of the original credit limit.
It’s very likely that you will create a much bigger debt than you originally anticipated paying off. In fact, many people in this kind of financial trouble end up using an installment loan to consolidate their debt into manageable monthly payments.
One of the biggest risks involved with revolving credit has to do with its massive impact on your credit utilization. Credit utilization is the ratio of the amount of credit used to the total amount available on the credit line. To determine your credit utilization, simply divide the two numbers.
Among the factors used by credit bureaus, credit utilization determines 30% of your overall credit score, second only to payment history (at 35%). Let’s take a look at that $1000 line of credit we talked about earlier – the one that has a balance of $500 on it. Since you are using half of your available line of credit, your credit utilization ratio would be 50%.
Most experts believe you should try to keep your credit utilization around 10%–25%. On the other hand, a 0% credit utilization ratio can also negatively affect your credit score, so the key is to make regular purchases and on-time payments.
Revolving Credit vs Installment Loan: What Should You Use?
Installment loans – if properly managed with regular monthly payments – can improve your credit score by creating a strong payment history. Revolving credit, if used conservatively, can also help your score by keeping your debt ratio low. Each option can be a boon to your financial security.
With that in mind, the best option is to have a little bit of both.
This varied approach to using credit can have another positive effect on your overall credit health by improving your credit mix, a determining factor that accounts for 10% of your credit score.
Strong credit scores are attached to people who have several different types of credit accounts. A person with a good credit mix might have a mortgage, car loan, and perhaps a couple of credit cards.
For people who already struggle with their debt, having several open accounts may seem like a sign of irresponsibility. But in fact, showing that you can manage a portfolio of accounts with varied repayment agreements and schedules will speak volumes to the credit bureaus that set your credit score.
Credit, in its many forms, is a powerful tool that can help us shape the lives we want for ourselves. While powerful, it is also delicate and must be handled with care and attention. So, take the time to research and review as many options as you can.
When you understand the options available when it comes to taking on debt, you will be able to make decisions that will help you stay on the fastest path to getting out of it.