When it comes to buying a home, getting a degree, tackling a home improvement project or even paying off debt, you may not have the cash on hand to pay for it all at once. These are all times when credit may be your best financial option.
There are two types of credit: revolving and nonrevolving (also known as installment credit). Each type can be useful in different situations, and each has its pros and cons.
We’re here to answer your questions regarding installment vs. revolving credit. We’ll outline the differences between the two, the specific pay schedules of each, and which option is best for the average consumer.
What is installment credit?
Installment credit is a type of credit in which you make fixed payments over a defined period of time. Typically, the amount borrowed is a predetermined amount of money. You must repay this principal to the lender, plus interest. The lender determines the interest rate, repayment terms, and fees. Examples of installment credit include:
- Personal loans
- Car loans
- Student loans
Let’s look at one type of loan, a mortgage, as an example. You seek to buy a $500,000 home. You pay 20% down and secure a mortgage from a lender for the remaining balance of $400,000. The bank lends you $400,000 as a lump sum, which you use to complete the sale of your home.
You opt for a 30-year fixed-rate mortgage. For the next 30 years, your monthly payment to your issuer is $1,111.11 in principal, plus whatever interest you owe as well. These are minimum payments, and you can choose to pay more if you’d like. Because you secured a fixed-rate mortgage, your lender cannot change the interest rate. This means that your payments will be the same fixed amount for the duration of the repayment period.
Pros and cons of installment credit
Whether or not you’d prefer to take on installment debt depends a lot on your financial situation and how you manage money. On one hand, knowing how much you need to pay each month could be useful if you struggle to make on-time payments. When building your monthly budget, you can easily plan to make payments on your installment loans.
For example, let’s say that you have a payment of $125 a month toward an auto loan, a student loan payment of $500 per month, and a mortgage payment of $1,000 per month. Knowing that you have to pay these various credit accounts each month eliminates any surprises.
And, should you make these payments consistently, you can improve your payment history on your credit report. Your payment history is the biggest factor in determining your FICO credit score.
Installment credit is useful if you need an influx of cash for something you otherwise would not be able to afford — again, like a home, an education, or a car. However, you should also understand that installment credit could be risky and can have long-term consequences.
When you take out an installment loan, you tie yourself to one particular debt for a long time. It’s expected that it takes borrowers at least 10 years to pay off student loans. Mortgages are often only available in lengths of 15 or 30 years.
You must decide whether the short-term, lump-sum cash payment is worth tying yourself to a particular type of debt for an extended period of time and whether you can make minimum payments on the loan for the duration of the repayment period.
What is revolving credit?
One of the other types of credit is revolving credit. Unlike installment credit, which provides you with an upfront lump-sum cash payment, revolving credit provides a credit limit that you are free to use as you please. You are not obligated to use all of your available credit, nor are you required to use a minimum amount.
In addition, access to revolving credit funds is not a one-time thing. The amount of money you can use replenishes as you pay back the money you’ve previously spent. Once you pay off a portion of your balance, you’re free to borrow that amount again.
Credit cards and lines of credit are the two most common types of revolving credit accounts. This includes personal lines of credit, home equity lines of credit (HELOCs), and the line of credit offered by Tally, which you can use to pay down credit card debt.
Let’s say you apply for a credit card and are approved. Your lender offers a credit limit of $5,000. This means that $5,000 is the total credit available on the account. It’s the maximum amount that you can spend. Should you reach this limit, you can pay off the balance to regain access to funds and begin spending again.
For example, let’s say you have a medical emergency, and you have to max out your credit card to pay the bill, spending all $5,000. In order to make more purchases on your card, you’ll have to pay down a portion of the credit card balance. After receiving your next paycheck, you pay down $1,500. You now have an outstanding balance of $3,500 and are free to spend another $1,500 on your card.
This example shows how revolving debt is different from installment debt. With installment debt, you receive an upfront, lump-sum deposit. You know exactly how much you have to repay moving forward, and you cannot access additional capital. Revolving debt, however, fluctuates depending on how you use it. If you repay portions of your balance, you regain access to the credit and are free to use however you’d like.
Pros and cons of revolving credit
One of the primary benefits of revolving credit is that you are free to use it as you please. Installment loans are earmarked for specific purposes. For example, you cannot use a mortgage to buy a new car. Lines of credit, however, provide much more flexibility. You are free to use them as needed. For example, you can use a credit card for a wide array of things, such as:
- Medical expenses
- Everyday expenses, like groceries
- Home improvement projects
However, you should also be mindful that revolving credit can have higher interest rates than installment credit. For instance, credit cards have some of the highest interest rates of any type of credit. If you do not pay your balance in full each month, you can quickly rack up debt. While installment credit has fixed payments, repayments for revolving credit depend on how much you spend each month.
Of course, one way to combat this is to use a credit card payoff app like Tally. Though Tally itself is a type of revolving credit, it manages your credit cards efficiently to help save you money. The app automatically ensures that you make your minimum credit card payments each month while paying down your balances as quickly as possible, freeing up credit and cash.
Lastly, revolving credit can be a useful tool to help improve your credit history. Much like installment loans, you’ll be required to make minimum payments on your revolving credit accounts. Doing so will boost your credit score. But revolving credit also allows you to improve your score thanks to the credit utilization ratio.
Your credit utilization rate is the amount of revolving debt that you’re using divided by the amount that you have available. If you’re trying to build or maintain a good credit score, it’s best to keep your credit utilization rate below 30%. For instance, if you have $10,000 in available revolving credit, maintaining an outstanding balance of $3,000 or less will keep your credit utilization in the recommended range.
Some credit scoring models indicate that the credit utilization ratio can impact your credit score by up to 30%. A low credit utilization also demonstrates financial responsibility to lenders.
Installment vs. revolving credit — which is best for you?
When comparing installment vs. revolving credit, there are a couple of things you need to consider. Installment credit can be useful because it provides you with a large amount of cash upfront. It’s also a bit easier to manage and budget for in the future since your fixed payment amount should not change from month to month.
On the other hand, you are tying yourself to one debt for a significant amount of time. Installment loans can often take years to pay off, and you can only use those funds for a designated purpose. In that regard, they can be quite restricting.
Revolving credit is much more flexible. You can generally use the funds for whatever you’d like. You can also use as much or as little as you’d like. The credit limit extended to you by a lender is a maximum amount. You are not required to use this entire amount, nor are you required to use any at all. You only need to repay what you use, plus interest.
The answer to which is best, installment vs. revolving credit, depends on your financial situation and how you intend to use the funds. Installment credit is a no-brainer for a mortgage, while a credit card payoff app like Tally may be the right choice if you’re looking to use a line of credit with a lower interest rate to pay off credit card debt.
Perhaps, then, the best answer is “both.” Lenders want to see a healthy credit mix, meaning they want to see different types of debts in your profile. Your credit mix makes up 10% of your FICO score. By strategically blending both installment and revolving credit, you could improve your score and create new financial opportunities.