When used responsibly, credit can be a valuable tool to manage your finances and achieve specific goals, like owning a home. And use it we do. According to a 2021 Experian study, U.S. consumers carried an average of $96,371 in debt, including personal credit accounts like mortgages, auto loans, credit cards and student loans.
With credit playing such an essential role in our finances, it's important to understand the basics of consumer credit. Specifically, consumer credit typically comes in two categories: closed-end credit and open-end credit.
Closed-end credit allows you to borrow a specific amount of money for a finite term. By contrast, open-end credit is revolving credit like a credit card that enables you to borrow repeatedly with no specified repayment date.
How Closed-End Credit Works
So what is closed-end credit? Closed-end credit, such as an installment loan or auto loan, is for a specific dollar amount and time period. Once you are approved for closed-end credit, you'll receive the funds upfront and then repay it with interest in monthly installments over the loan's term. Unless you pay off the loan early, the final payment of the loan's term will bring your loan balance to zero, and your lender will permanently close your account.
To understand what fees and interest will cost for credit, you'll look at the annual percentage rate (APR). APRs are set by calculating the loan's interest rate, fees and other costs into a number, which is expressed as a percentage. Knowing your APR can help you understand the true cost you'll pay for your loan each year.
Here are some other details to understand about closed-end credit:
- APR can be fixed or variable. Personal loans, mortgages, auto loans and types of closed-end installment loans come with annual percentage rates (APRs) that can either be fixed or change over time. Closed-end credit may feature either a variable- or fixed-rate APR. With a variable APR, the interest rate (and monthly payment) on your loan may fluctuate up or down in line with national interest rates. By contrast, the interest with a fixed-rate installment loan remains the same for the life of the loan, resulting in monthly payments that also stay the same.
- These credit products may come with fees. Closed-end credit often has fees that are either paid upfront or over time. For example, auto loans, mortgage loans and personal loans usually have origination fees. Depending on the lender and the type of loan, the origination fees may be paid upfront as part of the closing costs or through the loan proceeds.
- Terms can vary. One important feature of closed-end loans are flexible terms that allow you to adjust your loan term to fit your budget. For instance, you can spread out your mortgage payments over 30 years or your car payments up to 84 months. Longer loan terms can make it easier to afford monthly payments, but shorter-term loans will typically save you money in interest charges.
- They may (or may not) require collateral. Closed-end credit may require you to put up assets or property as collateral on your loan. Your lender can use your collateral as payment if you default on your loan. Generally, your mortgage loan is secured by your home, while your auto loan likely uses your car as collateral. Credit cards and other forms of open-end credit are commonly unsecured, with no collateral required.
Closed-End Credit vs. Open-End Credit
Open-end credit is an account you can continually draw from as needed and only pay interest on the amount you borrow. The main difference between open-end credit and closed-end credit is this: Closed-end credit is taken out once, and has a specific repayment date; open-end credit, like credit cards, can be drawn from again and again, and there's no fixed due date for paying the balance in full.
Home mortgages and auto loans are types of closed-end credit, with the home and vehicle serving as the collateral. Personal loans are another popular form of closed-end credit. Most personal loans are unsecured, but some personal loans may require collateral, such as cash in a savings account.
Perhaps the most common example of closed-end credit is credit cards, which are typically unsecured. Secured credit cards are also out there, and can be useful for those trying to build or improve their credit. With a secured credit card, you'll typically put down a security payment which will become your account's credit limit.
Whether you have a secured or unsecured credit card, it's essential to make monthly payments on time, as this will help you build your credit history and credit score.
The Bottom Line
Closed-end credit can help you achieve important financial milestones like owning a home or car. This form of credit allows you to repay a loan over an extended period, making financial goals more achievable. What's more, making timely loan payments and paying off your loan can boost your credit.
Generally, a higher credit score can make it easier to qualify for loans, credit cards and other credit products. Before you apply for credit, it's a good idea to get your credit score for free at Experian. Review your credit summary to discover how lenders may view you and learn the most significant factors affecting your credit score.