Learning the distinction between revolving credit and installment credit provides a better understanding of how credit works in general and can help you make better financial decisions.
Installment loans and revolving credit are the two primary credit types available to consumers. While they both involve borrowing money and paying it back monthly, there are important differences between them and reasons to choose one over the other, depending on the situation.
When it comes to choosing an installment loan versus revolving credit, the type of credit that appears on your credit report and in your credit score matters less than other financial factors, such as how well you make monthly payments on time. However, having at least some of both kinds on your credit report can improve your score over having just one type.
Here’s what you need to know about installment loans and revolving credit, when to use each type, and how to make them work for you.
Installment Loans Vs. Revolving Credit
The most significant difference between installment loans and revolving credit accounts is how you can use each kind. The type of loan is determined by what money is available to you and when. Credit cards versus personal loans, and home equity loans versus HELOCs are good examples of the primary differences.
For instance, if you take out a car loan, a type of installment credit, you’ll have access to a lump sum of money all at once. On the other hand, obtaining a revolving credit account allows access to a set amount of money that you can choose when and for what to spend it on.
Choosing one over the other is often a matter of what’s offered for various types of purchases. Home loans or mortgages are simply too large to be considered for revolving credit while paying for a night out on the town with an installment loan would be overkill.
Installment loans and revolving credit accounts will both appear on your credit report. They differ somewhat in how they affect your credit scores. However, knowing those differences and managing your credit can save you money and help you build and maintain favorable scores.
Related Article: Personal Loan vs Personal Line of Credit: Which One’s Right for You?
What is an Installment Loan?
An installment loan is a type of credit that happens when a borrower receives a lump sum of money for a specific purchase or reason and then pays back the borrowed money in equal payment amounts over a specific time period.
Many installment loans feature collateral, which acts as security for the lender that you’ll pay the money back as agreed. These installment loans can be referred to as secured loans. However, not all installment loans are secured with collateral. Personal loans used for debt consolidation or other reasons are often available as unsecured loans.
Types of Installment Loans
Several types of installment loans are available and fall into secured or unsecured categories. Secured loans often feature lower interest rates, while unsecured loans have higher APRs and often involve shorter payback times.
- Mortgages are secured by the existence of the home
- Personal loans can be secured or unsecured
- Student loans and student loan refinancing are unsecured loans
- Auto loans are secured by the automobile
- Other personal loans for RVs, boats, and similar items are often secured by the item purchased
- Refinancing installment loans are usually unsecured
What is Revolving Credit?
Revolving credit accounts are, effectively, loans that you can use at your discretion to make purchases without having to gain approval in each buying situation. Where installment loans provide a lump sum, revolving accounts allow access to a specific amount, your credit limit, that you can choose how and when to use.
Revolving credit accounts are also available in secured and unsecured formats. How you manage your revolving credit account and your monthly payments can make revolving credit an excellent asset or money pit.
Types of Revolving Credit
Several types of revolving credit accounts exist. The differences between them come down to whether or not they are secured with collateral. The most common and familiar type of revolving credit account is a credit card. Revolving credit typically features higher interest rates than installment credit types. However, paying the balance off each month can minimize the APR’s effects.
- Credit cards are often unsecured
- Secured credit cards are usually secured with cash in a deposit account with the lender
- Home equity lines of credit (HELOC) are secured with the equity in the home
- Other lines of credit may be secured or unsecured
- Personal lines of credit are often unsecured
How Installment Loans Work
Installment loans have some definite advantages, depending on what you’re trying to achieve by borrowing a specific amount of money. The lump sum payment that you receive as a borrower is a set number that won’t increase over time, provided you make the agreed-upon monthly payments. Most lenders allow you to pay off your loan early without penalty. However, this is an important detail to make sure of if you plan to do that.
In mortgages, auto loans, and other large purchases, the lender most often pays for your purchase for you without you ever having to handle the cash. For personal loans, you may or may not have to disperse the funds.
In either case, you’ll receive one payment, which will represent your beginning loan balance. This amount can also include origination and other fees that are added to the total amount you owe. Before borrowing the money, you’ll know how much your monthly payments will be and what interest rate you’ll pay, except in the case of adjustable mortgages or ARMs.
With an installment loan you must pay the minimum amount due each month, and you can usually pay extra against the capital to reduce the interest cost over the life of the loan. However, there is no effective way to completely avoid paying interest charges in some amount.
Installment Loan Pros and Cons
Understanding the pros and cons of installment loans will help you better utilize them as a financial tool.
Pros
- Fixed borrowing amount that won’t increase if you make monthly payments
- Predictable payments and payment schedule
- Generally feature lower interest rates than revolving credit
Cons
- Will roll off of your credit report several years after the account closes
- Cannot extend the amount of time the loan will remain on your report
- You can only reduce total interest costs, not completely remove them
How Revolving Credit Works
Revolving credit also involves a set amount of money. However, you don’t have to use it all immediately or even at all. When you get a revolving credit account, such as a secured or unsecured credit card, you’ll be given a credit limit. This is the amount of money you can borrow against, pay down, or pay off and use again for future purchases.
Secured and unsecured revolving credit accounts are available and collateral works differently for secured revolving credit than for installment loans. In a secured installment loan, the collateral is most often tied directly to the loan. In the case of secured revolving credit, the collateral is often a cash account or equity in your home if we’re talking about a HELOC.
While the interest rates for revolving credit accounts are generally higher than those for installment loans, in the case of credit cards, you can minimize the effects of the APRs by paying off your balance each month. Doing so saves you 100% of your interest charges versus carrying a balance from one month to the next when interest is calculated against your balance.
With revolving credit, you’ll have a minimum payment due each month, which represents a portion of your outstanding balance. This differs from installment loans in that the amount you pay each month can vary based on how much you spend with the account.
Revolving Debt Pros and Cons
Knowing the pros and cons of revolving credit can save you money, making it excellent for things like emergencies or one-off purchases.
Pros
- Interest can be avoided by paying off the balance each month
- Borrow against your credit limit at will
- Remains on your credit report as long as the account is open
Cons
- Higher interest rates than installment loans
- Minimum payments represent a small fraction of your balance
- Easy to overextend your borrowing capacity and ability to make payments
| Installment Loans | Revolving Credit | |
| Use For | Mortgages, auto loans, personal loans, and boat, RV, motorcycle, and other loans | Home remodeling, repairs, small purchases, emergencies, intermittent expenses |
| Features | Fixed payment amounts, lower APR, set payment schedule, balance will not increase, must pay interest | Variable balance based on your spending, higher APR, minimum payment requirement, ability to avoid interest costs |
| Credit Score Effects | Generally more favorable by credit bureaus due to lower perceived risk | Less favorable to credit bureaus due to increased risk of overextending borrowing capacity, |
Installment Loans Vs. Revolving Credit: Credit Utilization
How you use your credit, whether an installment loan or a revolving credit account, is crucial to increasing and maintaining favorable credit reports. Installment loans and revolving credit accounts differ in how they affect your scores.
While installment loans look better to credit bureaus than revolving credit, having both types on your report shows that you can handle different types of credit accounts, which will override any negativity regarding installment loans versus revolving credit.
With installment loans, potential lenders know precisely what they’re getting into when loaning you money. Conversely, if your report contains several revolving accounts, a lender could see the potential of increased debt on your part as a negative.
However, there’s another way each type can affect your ability to obtain credit in the future. Because revolving credit accounts have a credit limit, they are subject to what’s called a credit utilization ratio. This means that the more you use of the money (credit limit) available to you, the less desirable you make yourself to potential lenders. Lenders are more likely to extend additional credit to borrowers who keep their credit utilization ratio below 30%, and the lower, the better.
Installment loans can also affect your ability to obtain credit. While the credit utilization ratio doesn’t come into play, your debt-to-income ratio does. If you have several installment loans, a potential lender will balance how much income you have against how much your monthly payments are when making a decision to extend more credit your way. An acceptable debt-to-income ratio is 35% or less.
Installment Loans Vs Revolving Credit – Which is Better?
Neither installment loans nor revolving credit is better. They are simply different from one another. Installment loans are excellent tools for making large purchases or securing a fixed-payment amount while consolidating revolving or other unsecured debt. On the other hand, revolving credit offers maximum flexibility, and you can choose to pay as much or as little in interest as you like, provided the account is in good standing.
