Having access to credit can serve some important purposes, including creating liquidity and helping you to improve your credit score. Not only can responsibly using your debt help to boost your score, but the type of debt you use also plays an important role.
Installment loans and revolving debt are the two primary categories of credit. One allows you to borrow money a single time and pay it back on a predetermined schedule. The other gives you regular access to credit as long as you continue to pay it back. Both types of debt can be helpful in certain situations, and having both on your credit report can be a good thing for your credit score.
Keep reading to learn the similarities and differences between installment loans and revolving debt, the pros and cons of each, and how to decide which is right for you.
Differences Between Installment Loans and Revolving Debt
Installment loans and revolving debt have one key characteristic in common: They both give consumers access to credit, which can help them to fund large purchases, create liquidity in their budget, and boost their credit score. But there are several important differences between the two types of credit, which we’ll cover in more detail below. Differences include:
- Types of credit available
- How the debt is issued
- Ways the debt can be paid back
- How they affect your credit
Types of credit available
The first key difference between installment loans and revolving debt are the types of credit available. When you take out an installment loan, you have several options, including a mortgage, auto loan, student loan, and personal loan.
Certain secured installment loans, such as mortgage and auto loans, are secured by collateral, meaning your home or vehicle. But student loans and personal loans are unsecured.
There are also several types of revolving debt to choose from. Credit cards are the most prevalent type of revolving debt. In fact, 2020 data from the Federal Reserve Bank of Atlanta found that about 79% of consumers report having a credit card. Like student loans and personal loans, credit cards are a type of unsecured debt, meaning there is no collateral backing them up.
Another less common type of revolving debt is a line of credit. Some banks offer unsecured lines of credit that function similarly to a credit card. Others offer home equity lines of credit (HELOC), which allow homeowners to borrow against the equity in their homes. This type of revolving debt is secured by the home itself.
How the debt is issued
Another key difference between installment loans and revolving credit is the way they are issued. When you borrow an installment loan, you receive the entire amount in a lump sum. In some cases, you receive the money directly. There are other cases — especially in the case of secured loans — when the lender sends the money directly to its intended recipient.
For example, if you borrowed a student loan, the lender might send the funds directly to the school you’re attending. Similarly, when you borrow money for a home or car, the lender is likely to make the check out to the seller.
In the case of revolving debt, you don’t receive the full amount of money right away. Instead, you have access to the full amount, which you can choose to use or not use. For example, if you opened a credit card with a limit of $10,000, the bank wouldn’t give you a check for $10,000. Instead, that’s simply the amount that’s available on the credit card if you choose to use it.
How the debt is repaid
Just as installment loans and revolving debt differ in the way they are issued, they also differ in the way they’re repaid.
When you borrow an installment loan, you’re placed on a repayment plan with a predetermined term. The loan term depends largely on the type of loan. A personal loan or auto loan may be repaid in just a few years, while mortgages often have terms of 30 years. An installment loan calculator can be used to get a rough idea of monthly payment amounts based on the loan terms.
Each loan has an amortization schedule that determines your monthly payment. There is interest applied to the loan, and each payment has a portion going toward principal and interest.
The repayment schedule for a revolving debt is far more flexible. With this type of credit, you only make monthly payments if you’ve actually used some of your available credit. The minimum amount due will be a percentage of your total outstanding balance, along with interest.
With revolving credit, interest applies only to the amount of debt you’ve actually used rather than the full amount. If you had a $10,000 credit limit but a balance of only $100, interest would only apply to the $100 balance. Additionally, in the case of credit cards, interest doesn’t apply if you pay your full balance each month.
It’s important to note that the flexibility that comes with revolving debt can lead to trouble. The interest rates on credit cards are higher than most other types of debt. And since you only have to make the minimum payment each month, it’s easy to rack up credit card debt and become overwhelmed with the large interest payments.
How they affect your credit
A final key difference between installment loans and revolving credit is how each affects your credit. In both cases, your payment history is an important factor.
If you make your monthly payments on time each month, they’ll appear on your credit report and help boost your credit score. But if you make a late payment, it will also appear on your credit report and can hurt your score.
Revolving credit has an additional effect on your credit in terms of your credit utilization. Credit utilization refers to the percentage of your available revolving credit you’re using. Higher credit utilization can harm your credit score, while a utilization below 30% can help your score.
Pros and Cons of Installment Loans
Pros and Cons of Revolving Debt
Which One Is Right for Me?
When you’re deciding whether an installment loan or revolving credit is the right choice for you, it’s important to consider what you’ll be using the money for.
Installment loans are often best for large purchases like a home, car, debt consolidation, or college education. On the other hand, revolving debt is best suited to ongoing spending and unforeseen expenses.
While each type of credit is best for certain situations, it’s actually best for your credit to have both installment and revolving debt on your credit report.
Your credit mix — meaning the variety of types of debt on your credit report — makes up 10% of your credit report, and having both can help to boost your credit score. It shows lenders you can responsibly use different types of debt.
