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There are two common types of credit accounts: revolving credit and installment credit. Both allow you to finance purchases, but the terms and how you receive the money differ.
Revolving credit allows you to borrow money up to a set credit limit, repay it and borrow again as needed. By contrast, installment credit lets you borrow one lump sum, which you pay back in scheduled payments until the loan is paid in full. Both types of credit accounts can help—as well as potentially harm—your credit depending on how you manage them. Find out what revolving and installment credit are and the pros and cons of each.
What Is Revolving Credit?
A revolving credit account allows you to repeatedly borrow money up to a preapproved limit and repay it over time. Credit cards, personal lines of credit (LOCs) and home equity lines of credit (HELOCs) are all types of revolving credit. Banks, credit unions, credit card issuers and other lenders provide revolving credit accounts.
When you're approved for a revolving credit account, the financial institution sets a credit limit that you can borrow up to repeatedly. Generally, you can pay off the balance in full, make minimum payments or choose another payment amount each month.
Revolving credit can be either secured or unsecured. A secured line of credit is backed by collateral, such as your home (as with a HELOC), while unsecured revolving credit is not. And, although the interest rate you pay on a revolving credit account could be higher than with an installment loan, you only pay interest on any balance that you carry over, or "revolve," from month to month. With a HELOC, you'll likely also pay closing costs on the loan.
Pros and Cons of Revolving Credit
Revolving credit can be a convenient way to pay for purchases or even fund a large project, like a home renovation. However, like most types of credit, there are advantages and drawbacks.
Pro: Only Borrow What You Need
With revolving credit, you only borrow what you need. When you pay down or pay off the balance, that money is again available for use, minus any interest charges or fees. Plus, you only pay interest on any balance you carry over from month to month.
For instance, if your credit line is $75,000, but you only use $50,000, you only pay back that portion plus interest if you carry a balance over time. If you have a $75,000 installment loan, you will have to pay back the full $75,000 (plus interest) even if you don't use it all.
Pro: Easy Access to Funds
With revolving credit, you can access funds when needed, up to the approved maximum credit amount set by your lender. With credit cards, the approval process is usually quick. Qualification requirements for the best interest rates and terms on a credit card, HELOC or LOC can depend on your credit score, income, credit history and other factors. But once your revolving credit account is approved, you can access it easily to pay for purchases and other needs.
Note that because a HELOC is secured by your home, your lender will conduct a property appraisal to determine your home's value and establish how much equity it will allow you to borrow. That, combined with the credit review process, may mean a delay of a few weeks or longer in receiving your funds, assuming you're approved.
Pro: Possible High Borrowing Limits
Revolving credit can have fairly high loan limits depending on the lender and other factors. An unsecured line of credit may have limits from $300 to $100,000. Lenders typically limit a HELOC to 60% to 85% of your home's equity, minus the balance on your mortgage. Credit card limits can be as high as $500,000, but $10,000 or less is more common.
Con: Preset Borrowing Limits
When you are approved for revolving credit, you are given a credit limit—the maximum amount of money you have access to—by your lender. Although credit limits can be high, your limit usually depends on your overall credit. If you have poor credit, it may be challenging to qualify, and you may only be eligible for a smaller amount.
Con: Potential for High Interest Rates
Credit cards often have high interest rates when compared with other types of credit. The higher your revolving balance, the more interest you'll pay on any balance you carry over. Depending on your balance, your minimum payment can also be high.
Revolving accounts typically have variable interest rates, which can increase or decrease depending on economic conditions. That means you could end up with a higher rate on a balance you carry over, which could add a substantial cost if your balance is high. You can avoid paying interest if you pay off your revolving credit line in full every month.
Con: Chance of Overspending
Although most types of credit have the potential to either benefit you or set you back, it often comes down to how you use it. With almost immediate access to funds up to your credit limit, it can be tempting to spend more than you can easily afford with revolving credit. Using only the funds you can repay in full each month helps boost your credit score without going into debt, while falling behind or missing payments altogether can hurt your credit.
What Is Installment Credit?
Installment credit is a type of loan where you borrow a lump sum of money, which is paid back in fixed amounts—usually monthly—called installments. The repayment period can be several months to many years. Mortgages, auto loans and personal loans are all common types of installment credit.
When you apply for an installment loan, your lender will consider your credit score, credit history, income, outstanding debts and other factors. Interest rates can be fixed or variable, and you may be charged additional fees, such as origination fees or closing costs. Comparing multiple lenders can help you get the best rates and terms.
Pros and Cons of Installment Credit
Installment loans can be tailored to your specific needs, whether a mortgage, car loan or personal loan. It's also possible to obtain a lower interest rate than with some revolving credit accounts, such as credit cards, if your credit is good. There are drawbacks to consider as well.
Pro: Receive a Lump Sum
With an installment loan, you borrow a fixed sum of money and make monthly payments until the loan is paid off. Because it is distributed in one lump sum, you may be able to fund a large purchase, consolidate high-interest debt or pay for an unexpected emergency. For example, a mortgage provides a large amount of cash so you can buy a home or, with a home equity loan, borrow money against the value of a home you already own.
Pro: Fixed Rate and Payment
The interest rate and payment on an installment loan typically stay the same throughout the term of your loan. You know exactly what you will pay each month, making it easier to stick to a budget. This isn't the case with all mortgage loans, however; adjustable-rate mortgages have rates that can fluctuate due to market rates and the terms of your loan.
Pro: Flexible Repayment Terms
An installment loan can have a repayment period of months or years. Mortgages typically offer 10-, 15- or 30-year terms. Car loans generally come with 36- to 72-month terms, with longer terms becoming increasingly common. Repayment terms on many personal loans are two to five years.
If you want to pay less interest and can afford a higher monthly payment, you can choose a shorter loan term. Paying over a longer period of time will give you lower monthly payments, which can help with your monthly cash flow needs, but will usually cost you more interest charges over the life of the loan.
Con: Loan Fees
Some installment loans have added fees tacked onto the loan amount, which adds to the total cost of your loan. You may pay an application fee, origination fee, late fee and possibly a prepayment penalty for paying off your loan early. With a mortgage loan, you'll also likely pay closing costs.
Con: Possible Damage to Credit
Making a late payment on your installment loan or missing payments altogether can damage your credit. In fact, late payments can remain on your credit report for up to seven years, making it challenging to apply and qualify for credit in the future.
Con: No Flexibility on Payments
Although fixed payments can make it easier to stick to your budget, there may be times when repaying your installment loan becomes difficult or impossible, such as if you lose your job, for example.
With an installment loan, you are locked into a long-term obligation. If your circumstances change, you may not be able to meet your scheduled payments. If that happens, you risk defaulting on your loan or losing any collateral used to secure the loan.
Revolving Credit vs. Installment Credit
| Revolving Credit vs. Installment Credit | |
|---|---|
| Revolving Credit | Installment Credit |
| Money is borrowed, repaid and borrowed again as needed up to a set credit limit | Distributed as a lump sum with fixed, scheduled payments |
| Typically has higher interest rates | May be harder to qualify for |
| Interest is charged only on the amount you borrow | Fixed payments are paid back over a predetermined time period |
Revolving credit, such as a credit card, makes sense when you plan to repay the amount borrowed by the due date. It can also make sense if you earn points or miles, or get cash back. However, interest is accrued on any balance carried over each month and can be higher than with installment credit.
On the flip side, an installment loan, like a car loan or personal loan, may be best if you want fixed payments that are paid back over a set period of time. This can make it easier to stick to a budget because you know exactly what you're paying out each month. However, an installment loan can be harder to qualify for unless your credit is good or excellent.
The Bottom Line
Because payment history is the most important factor when calculating your credit score, making all your monthly payments on time is crucial. Late or missed payments on either revolving or installment credit accounts can negatively affect your credit. Conversely, making on-time payments can help improve your credit over time. Check your credit score for free at Experian before applying, and, if needed, improve your credit before you apply to get the best rates and terms possible.