Revolving credit and instalment loans are two of the most common types of credit that you’ll encounter. While these products may look similar on the surface, they’re actually different in several respects.
From the way they work to their impact on your credit scores, the differences between revolving credit vs. installment loans are great.
Revolving Credit vs. An Installment Loan
Before you apply for either of these credit products, it’s important to understand them. So, here’s a quick breakdown of each product to give you an idea of how they work:
Revolving Credit
This type of credit lets you borrow repeatedly from a set dollar limit, then repay it monthly balances. Every time you make a payment, it restores the amount of credit you have left on your account (minus interest and fees). Popular revolving credit products include credit cards and lines of credit.
Installment Loan
An installment loan lets you borrow a fixed amount of money over a specific term. You’ll then repay that amount in installments. While many loans have fixed interest rates, variable rates may be possible too. Some of the most common loans include personal loans, student loans and car loans.
Key Differences Between Revolving Credit And A Loan
Here are some of the main contrasts to know about revolving credit and loans. Make sure to research these differences so you don’t encounter any problems down the road:
Repayment
With revolving credit, there’s no set repayment term. So long as you meet your product’s minimum monthly payment requirements, you can borrow from your credit product indefinitely.
On the other hand, loans are divided into installments and you must pay your total balance back by a specific due date.
Interest Rates
While you can make minimum and partial payments to avoid penalties, revolving credit rates tend to be higher than installment loan rates. However, rates can also vary depending on your credit scores, income, debt levels and overall financial health.
Moreover, with revolving credit products, interest is only charged on the amount you use, not the entire credit limit. With installment loans, the interest is charged on the entire amount.
Debt-To-Credit Ratio
Revolving credit affects your debt-to-credit ratio (a.k.a. credit utilization ratio). This refers to the amount of credit you’ve used versus how much you have. In general, it’s recommended that you keep a ratio of 30% or under.
Installment loans do not affect your debt-to-credit ratio.
Types Of Revolving Credit
In Canada, borrowers can apply for several types of revolving credit, including:
Credit Card
Potentially the most common revolving credit product is the credit card, which features a specific credit limit that tells you how much money you can spend on it. As mentioned, paying down your debt balance will replenish your credit limit from month to month.
Prior to signing up for a credit card, be aware that interest will accumulate against any outstanding balances on it, so it’s best to make full monthly payments whenever you can. All this makes credit cards perfect for smaller, everyday purchases, like groceries.
Line Of Credit
Like a credit card, a personal line of credit gives you access to a predetermined credit limit, which regenerates as you make payments. You typically need to apply through your bank or credit union but some alternative lenders will offer lines of credit as well.
If you qualify, you’ll have a specific “draw period”, during which you can withdraw money from the account. Once again, interest will be applied to your unpaid balances and you’ll have the option of making minimum or partial monthly payments to avoid late penalties.
HELOC
If you have enough equity in your home (usually somewhere around 20%), a Home Equity Line of Credit lets you dip into it for a preapproved term, similar to a personal line of credit. Your credit limit is decided by the lender, based on how much equity you have.
Watch out, because a HELOC is secured against your equity, which means the lender can seize your home if you miss too many payments. However, since security is present here, you may qualify for lower interest rates than other types of revolving credit offers.
How Does Revolving Credit Affect Your Credit?
Depending on how you use it, revolving credit may impact your credit in these ways:
- Credit Inquiry – When you apply for revolving credit, your lender may check your credit report, which will lead to a hard inquiry. This may cause a small, temporary drop in your credit score and be recorded in your credit report for at least 2 years.
- Debt-To-Credit Ratio – You must be careful with revolving credit, because if you use up too much of your available credit, your credit may be affected. It’s recommended that you maintain a ratio of 30% or less.
- Payment History – Your payment history is a common and often significant factor when calculating credit scores. So, if you constantly miss payments on your credit card, line or credit or HELOC, it can negatively affect your credit.
- Credit History – Your credit history refers to the age of your credit accounts. So when you open or close a revolving credit product it can affect your credit scores.
How Does An Installment Loan Affect Your Credit?
A loan can affect the same factors as revolving credit, except for the debt-to-credit ratio:
- Credit Inquiry – Applying for a loan can also lead to a hard inquiry on your credit report too. In general, it’s best not to apply too many times within a short period of time.
- Payment History – An installment loan doesn’t give you the option of making minimum or partial payments. So, making partial payments is still considered a missing loan payment.
- Credit History – Like revolving credit, opening and closing installment loan accounts can affect the age of your credit history.
Revolving Credit And Credit Card Debt
At the end of your credit card’s billing period, you don’t have to pay off the full balance, you can simply pay something the minimum payment. This might sound like a good thing, but it’s one of the fastest ways to get yourself into debt.
What Is A Minimum Payment?
The minimum payment on a credit card varies based on your balance and your credit card issuer. However, in general, the minimum payment on a credit card is the higher of these two amounts:
- A flat fee of $10
- 3% of your current balance
Is Revolving Credit Right For You?
Depending on your financial circumstances, either a revolving credit or an installment loan can prove useful. While a revolving credit provides flexibility an installment loan provides more structure and lower rates.
