The financial world is full of terms that may seem confusing if it isn’t a field with which you are familiar. It’s important to educate yourself on the different types of credit available before submitting applications, especially if you’re trying to establish or rebuild your credit. Knowing the difference between installment loans and revolving credit will help you make wise financial decisions as you diversify your credit mix.
What is installment credit?
An installment debt is repaid in incremental scheduled payments. It is a loan whose principal amount is reduced with each payment until the debt is fully paid, thus ending the credit cycle. Some examples of installment loans are auto loans, personal loans, and mortgages.
What is revolving credit?
Borrowers are allowed to spend the money they’ve been lent, repay the debt, and spend it again. With revolving credit, lenders give the borrower a set credit limit that can be used entirely or in part. Examples of revolving credit are credit cards and personal lines of credit.
Why is a mortgage considered an installment line of credit?
Mortgage loans by themselves are considered installment debt because there is a specified amount the borrower is entitled to receive and required to repay. The pre-set payments are made in monthly installments and must be repaid by the contract’s end date.
Can a mortgage be revolving credit?
A home equity line of credit (HELOC) is a form of revolving credit as it allows you to borrow from the equity in your home. You aren’t given a lump sum of money, as would be the case with installment loans. Instead, you can continuously borrow against the equity, with certain limitations.
Unlike a credit card, obtaining a HELOC is a bit more difficult. You must own a home and have equity in it before you start searching for a lender. Once you find one, you can apply for a line of credit, and the lender will require you to submit W-2s, tax returns, and paystubs to establish whether to lend the money and the terms of the agreement.
Benefits of using installment credit
An installment credit account has advantages and disadvantages you should consider before committing to one. Let’s take a look at some of the pros.
Lower interest rates
The interest rates for installment debt are much lower for borrowers with good credit. Revolving credit as it relates to credit card charges compounding interest rates each month you carry over a balance. High-interest rates are more expensive to carry over the long term, which is why installment loans can be a much more attractive option than revolving credit.
Predictable monthly payments
Knowing how much your monthly payment will be upfront makes it much simpler to manage your finances. Budgeting is easier as you don’t have fluctuations in the payments as you would making minimum payments on a credit card. Installment loans can have an extended period for repayment, which can lower your monthly installment and allow you to keep your cash flow healthy.
Boost in credit score
Even if you have poor credit, you can still get an installment loan with a repayment schedule that can help you rebuild your score. On-time payments are reported to the credit bureaus, and your credit mix is broadened, which will both boost your score.
Although applying for the installment loan is a hard inquiry that will lower your score in the short term, making consistent, timely payments will grow your score over time. That boost will improve your chances of obtaining better interest rates in the future.
Disadvantages of installment credit
While there are benefits to securing an installment credit account, there are a few drawbacks as well. For starters, many lenders won’t allow you to prepay the loan balance without incurring a prepayment penalty first.
That means you cannot pay more than the required monthly installment or pay off the loan in its entirety without incurring a penalty. This clause is part of most mortgage contracts, unfortunately.
The penalty is often based on a percentage of your remaining mortgage balance, and the interest rate is based on your credit score. If you have a poor score, you can expect higher interest rates. Installment loans also have strict qualification guidelines regarding income, outstanding debt, and credit history, so revolving lenders tend to be more lenient, even for high-risk borrowers.
Installment loans are also based on your reported income. That means if you miss a few shifts or are fired, you can experience a cash flow problem that will affect your ability to repay the loan. Restructuring installment loans may reduce your monthly payment, but you will end up paying much more than the original amount borrowed over time.
Make sure you read the loan agreement carefully, as some installment loans come with deceptive add-on fees and excessive rates that can also cause you to pay back more than you borrowed. You may be in a bit of a cash crunch and think this is your best option, but you might be better off applying for a line of revolving credit to help you through the tough times instead.
Improve your credit with an installment loan
Making the choice between revolving credit and installment loans will depend on your current needs and credit situation. If you are looking to improve your credit score, the monthly on-time payments reported to the credit agencies will benefit you in the long run. Not only will your credit score increase, but the interest rates offered to you will decrease significantly as well.
FAQ
What type of credit is an installment loan?
Installment loans give borrowers a fixed line of credit to work with for a specified amount of time, during which they must make regular monthly payments until the debt is fully repaid.
Is a mortgage an installment loan or revolving credit?
Since a set amount must be paid back every month, mortgages are installment loans.
Is a mortgage a revolving account?
No, you cannot spend the borrowed money and repay it to borrow again.
