Revolving Credit vs Installment Credit
Credit And Promise To Repay
If you are new consumer, a clear understanding of “revolving credit” vs “installment credit” will help you manage your credit accounts, debt obligations and credit profile. When you receive credit from a lender you enter into an agreement to purchase a good or service with the express promise to pay for it later. The lender defines the terms of this promise to repay and you, as the borrower, accept these terms to repay the debt. Revolving credit vs installment credit are the two basic forms for repaying credit which corresponds to your promise to repay your debt to your lender.
Two Types Of Credit Repayments
When you get credit there are basically two repayment types: revolving credit vs installment credit. Each type is different and is mutually exclusive. That is, it is one or the other, they can not be mixed.
Installment credit is in the form of a loan with the amount determined at the time of approval, that does not change over time. where the borrower receives the money in advance. The borrower repays the loan with scheduled, periodic payments, normally monthly. This type of credit gradually reduces the loan principal and eventually full repayment of the debt. This ends the credit cycle and closes the credit account. An example would be an auto loan.
Revolving credit is a form of lender contract where the borrower receives a maximum line of credit balance determined at the time of approval. The borrower does not receive a pre-determined amount of money against the credit line balaance. The contract terms and line of credit balance amount can change over time, based on many factors. The borrower makes variable repayments against the line of credit balance, subject to contract minimums. There is no formal end to the credit cycle and the credit account remains open. An example would be a credit card.
Installment Credit Repayment
An installment credit account has a pre-established loan amount advanced, a predetermined interest rate, length and end date, often referred to as the terms 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 the loan.
Once the loan amount has been paid off, the installment credit account is closed. An additional credit application is required to borrow more money from the lender, basically opening a new installment credit account.
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. Most of the time these types of loans will be secured by some asset, such as a car or a home. The notable exception, of course, is a student loan.
With installment credit, you are provided a set monthly repayment amount for a stated period of time, making budgeting easier. Installment loans can also be extended over time, allowing for lower monthly payments that may align better with your monthly cash flow needs.
For qualified borrowers, installment credit can be less expensive than revolving credit as it relates to interest rates and user fees. Installment credit lenders offer lower interest rates, ranging from 2% for secured loans to 18% for unsecured loans.
Installment credit lenders often have stringent qualifications regarding income, other outstanding debt, and credit history. Also, some lenders do not allow you to pre-pay the loan balance which means you are not allowed to pay more than the required amount each month without being assessed a prepayment penalty
Revolving Credit Repayment
A revolving credit account has a maximum credit balance available to the borrower for any type of use, at any time, subject to the balance limit. Since the borrower does not receive a pre-determined amount of money against the credit line balaance, there is no specific repayment or amortization schedule. The lender can modify the credit account terms, particularly interest rates and penalty fees, based on changing maket conditions, the borrower’s creditwothiness or other risk factors. Primary examples are this type of credit account are credit cards and lines of credit.
The borrower makes repayments against the line of credit balance, as desired, subject to contract minimums. The credit account remains perpetually open, rolling over monthly. A revolving credit account normally is unsecured, but may be secured with an asset when a lower interest rates or higher credit balance amount is desired by the borrower.
Your Payment History (35% weight) on your debts is the most important component used in calculating your credit score. Regardless of the type of credit account in your credit report, of greatest importance is whether you pay them consistently and on time. This is the primary driver of your credit score. So first things first: no matter what type of credit account you have, pay it on time, every time. Otherwise, any late payments will be treated as negative, and you will pay for it.
Your Amounts Owed (30% weight) on your debts is the second most important component of a credit score. It indicates whether your spending habits are sustainable and if you are likely to face serious financial problems in the future. If you are using a lot of your available credit, this may indicate that you are overextended-and lenders can interpret this to mean that you are at a higher risk of defaulting.
Both FICO and VantageScore, when analyzing revolving credit vs installment credit accounts, treat them differently (weight) in your credit score calculations. That is, these two types of credit accounts are viewed differently in terms of how they predict future lender credit risk and consumer behavior.
Why Are They Treated Differently?
Revolving credit accounts like credit cards are unsecured debt and as such carry a greater financial risk to the lender, since there is no asset guarantee. The credit score models focus on the revolving credit utilization ratio (ideally less than 30%), which measures your credit card balances relative to credit card limits. The higher the amount of revolving credit debt, the higher the potential risk to the lender of your defaulting on payment. Your credit score will tend to drop since it measures the future risk of consistently, paying your lenders back on time.
Conversely, installment credit accounts, like an auto loan or home mortgage, are secured debts and pose less financial risk to the lender. The credit score models assign less weight to installment credit accounts risk, even though the amount of debt may be relatively high (e.g., $350,000 home mortgage) versus an outstanding credit card balance of $5,000. Borrowers will prioritize payments on their installment credit accounts, to avoid the potential loss of their collateral asset. The credit score models reflect this difference in borrower behavior.
In summary, revolving credit is much more predictive of future consumer credit risk and is more likely to adversely affect your credit score.
Revolving credit vs installment credit are the two basic forms for repaying consumer debt to a lender. Installment credit is in the form of a loan with the amount determined at the time of approval, that does not change over time. where the borrower receives the money in advance. Revolving credit is a form of lender contract where the borrower receives a maximum line of credit balance determined at the time of approval.
Credit score models, when analyzing revolving credit vs installment credit accounts, treat them differently (weight) in your credit score calculations. That is, these two types of credit accounts are viewed differently in terms of how they predict future lender credit risk and consumer behavior.
An overview of revolving credit vs installment credit is presented. This includes 1) Installment Credit; 2) Revolving Credit; 3) How They Affect Your Credit Score; and 4) Why There Are Differences.
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