Understanding the Different Types of Credit
Credit seems straightforward enough - borrow money and pay it back over time plus interest. But it's important to understand there are different types of credit and situations in which one may be a better financial choice.
The two main types of credit are installment and revolving credit. Mortgages are an example of installment credit while credit cards are an example of revolving credit.
How Installment Credit Works
People use installment loans to pay for expensive things like homes, cars and college costs. The loan is for a set amount of money and you receive the money in a lump sum. You have a pre-determined amount of time to repay the loan, usually several years. Your loan can have a fixed interest rate (does not change during the repayment period) or a variable rate (the rate can rise).
There are two types of installment loans:
- Secured loans: Your promise to repay is backed by an item of value like your home, which the financial institution can take if you don't pay back the money
- Unsecured loans: You don't put any property at risk, but the interest rate is usually higher and not repaying the loan will damage your credit rating, making it difficult to borrow in the future
Benefits of an installment loan:
- With a fixed rate loan, your payment is the same each month, making it easy to budget
- The interest rate is usually lower, which saves you money in the long run
- Your balance decreases over time as you make your payments, so your debt is not growing
- You pay interest only on the original amount you borrowed
How Revolving Credit Works
Revolving credit is an open-ended form of borrowing. You get a credit limit (the maximum you can borrow) and then use the credit and pay it back over time. As you use it, the amount of money available to you decreases. As you repay it, it goes back up.
Credit cards have some advantages:
- Once you have the card, there's no application or waiting time to get the money you want
- You have the flexibility to change your monthly payments if you need to
Credit cards usually charge annual fees and fees for going over your credit limit or making balance transfers. Since there is no set amount of time for paying your balance off, your debt can increase substantially over time. In addition, if you don't pay your full balance each month, you pay interest on both the amount of money you spent using the card plus the interest you've built up. The amount you owe can grow quickly.
- If you borrow $3,500 with a 10 percent annual percentage rate, fixed-rate loan with monthly payments over a term of five years, you pay $961.88 in interest
- If you charge $3,500 on a credit card with a 10 percent annual percentage rate and make only the minimum payment each month, it will take you more than 14 years to pay off the debt and you will pay $1,638.54 in interest. And that's only if you don't use the card and add more debt
Choose the Right Type of Credit
By knowing the pros and cons of installment and revolving credit, you can choose the right type of credit for your purchase and financial situation and work to build your good credit.
This article is for informational purposes only. For personalized financial advice, you should contact a qualified financial advisor.