Before you decide to borrow money, it's vital to know about the type of debt you are trying to take. One of the first things you need to understand is whether it's an installment loan or a revolving credit. Both types of debt can let you borrow money, but they work differently.
Installment Loans vs. Revolving Credit
Installments loans come with a fixed amount that you pay back on a set period. They tend to have a fixed interest rate, which means you know upfront how much you will pay in interest for your whole loan term. Installment loans may also have a variable rate, which means the interest rate is connected to a financial index and can fluctuate.
These loans are usually paid monthly. You will know in advance when your loan will be paid off. Plus, if it's a fixed-rate interest loan, you will be aware of the loan’s total cost.
Banks, credit unions, and even online lenders offer easy to pay off installment loans. Some examples of installment loans are car loans and personal loans.
As mentioned earlier, these two types of debt work differently. With revolving credit, you are given a maximum borrowing limit, and you can choose to use a small amount of that line of credit. For example, if you have a home equity line of credit worth $15,000, you can initially borrow $3,000 from it. Once you repay the $3,000 back, you can use that amount again if you like.
Some revolving credit is considered open-ended. It means your credit line can be open forever, and you can choose to borrow some money and pay it back whenever you want.
In some cases, you can also have a line of credit to use for a limited time. An example of this is a 10-year home equity line of credit.
In revolving credit, you don’t know in advance that how much the total borrowing cost will be or when you will repay your debt. That's because you borrow, pay, borrow again, and pay again while your line of credit is still open.
In most cases, revolving credit can also charge a variable interest rate, which means that the interest rate costs can unpredictably change over time.
When Can You Access Borrowed Funds
If you choose to get an installment loan, you can access the money in a lump sum. For example, if you take out a personal loan worth $15,000, the amount will be deposited in your bank account, or you will receive a check worth the stated amount.
If you plan to borrow more money, this can’t be done even if you have already paid off the loan. You will have to apply for a new loan to borrow more money.
However, with revolving credit, you can decide when to borrow funds. You can choose to borrow right after you open a credit card, or you can also wait for months or years to borrow. It all depends on what you want. If you don’t use your card for too long, it might get closed due to inactivity.
As long as your line of credit has not overpassed its maximum limit, you can borrow funds again and again.
Installment Loans and Credit Score
Installment loans can be straightforward in affecting your credit score. Payment history is the primary factor in determining the status of your credit score. Hence, as long as you make all the loan payments on your installment loan on time, it will certainly boost your credit score.
On the other hand, any missed or late payments will hurt your credit. If you pay on time, your debt balance will decrease. Plus, you will bring good progress to your payment history.
Revolving Credit and Credit Score
With revolving credit, you can choose the amount you want to borrow and how much you wish to pay (assuming you will pay the minimum required). Since payment history plays a crucial role in your credit score, it's vital to make your loan payments on time.
If you use revolving credit, a significant portion of your credit score can come from your credit card balance. Another variable is your current credit utilization ratio. That is how much you owe in your credit card statement in comparison to your available credit total.
In A Nutshell
Installment loans and revolving credit are types of debts that can help you borrow some money. However, both are entirely different. Understanding the differences between these debt types can help you decide which one works best for you.
Aidan has been writing about personal finance for over 6 years. Prior to this, he worked as a Corporate Finance Analyst where he specialized in Due Diligence, Company Valuations and more. He is a CFA charterholder.
