Installment Loans vs Revolving Credit - What Should You Choose?
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When it comes to managing your finances, choosing the right type of credit can significantly impact your financial health. Two popular options are installment loans and revolving lines of credit, each with its unique features and benefits. Installment loans are straightforward, offering a lump sum of money that you repay through regular, fixed payments over a set period.
On the other hand, a revolving line of credit offers more flexibility, allowing you to borrow up to a certain limit and make payments as needed. Understanding the differences between these two credit options is crucial for making informed financial decisions and managing your credit effectively.
In this article
What are instalment loans?
Instalment loans are a type of loan where you borrow a lump sum of money and repay it over time through regular, scheduled payments, known as instalments. Each payment typically includes both principal and interest. The loan term can vary, from a few months to several years, depending on the type of loan and the agreement with the lender.
Common examples of instalment loans include personal loans, auto loans, mortgages, debt consolidation loans or loans for large purchases. The structure of instalment loans makes them predictable and easier to budget for, as the payment amount and schedule are generally fixed.
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Pros and cons of instalment loans
Pros
- Predictable payments. Payments are consistent, making it easier to budget and plan. You know exactly how much you need to pay each month and when the loan will be fully repaid.
- Structured repayment.The loan term is set, so you know when the debt will be cleared. Payments typically include both principal and interest, which helps reduce the balance over time.
- Lower interest rates. Often have lower interest rates compared to revolving credit, especially for secured loans (e.g., auto loans, mortgages). Many installment loans come with fixed interest rates, providing stability.
- Goal-oriented. Ideal for specific large purchases or financial goals (e.g., buying a home, consolidating debt).
- Builds credit history. Regular, on-time payments can positively impact your credit score.
Cons
- Less flexibility. Payments are set and must be made on schedule, regardless of changes in your financial situation. Some loans may have penalties or fees for paying off the loan early.
- Upfront costs. Some loans come with upfront fees or origination charges, which can add to the total cost. May also include costs for processing or application.
- Potential for overextension. Committing to a large monthly payment can strain your budget, especially if unexpected expenses arise. Missing payments can lead to penalties, fees, or damage to your credit score.
- Limited borrowing flexibility. Once you make a payment, you cannot access the repaid funds without applying for a new loan.
- Fixed amount. You receive a lump sum and must use it all at once or according to the loan agreement.
What is revolving credit?
Revolving credit is a type of credit that allows you to borrow up to a certain limit and repay it over time. Unlike instalment loans, which have fixed payments, revolving credit gives you flexibility in how much you borrow and how you repay it. As you repay the borrowed money, your available credit is replenished, allowing you to borrow again up to the credit limit.
Common examples of revolving credit include credit card debt and home equity line of credit (HELOC). Revolving credit is useful for managing ongoing expenses and emergencies but requires careful management to avoid high interest charges and potential debt accumulation.
Pros and cons of revolving credit
Pros
- Flexibility. You can borrow up to your credit limit and repay at your own pace, making it ideal for managing varying expenses. As you repay, your available credit is replenished, allowing you to borrow again without reapplying.
- Convenience. Credit is readily available for emergencies or recurring expenses, such as monthly bills or unexpected costs.
- Variable payments. You’re usually required to make a minimum payment, which provides some flexibility if you have a tight month. You can pay more than the minimum to reduce your balance faster and save on interest.
- Potential rewards and benefits. Many credit cards offer rewards like cash back, points, or travel benefits.
- Building credit history. Responsible use, such as making timely payments and maintaining a low balance, can positively impact your credit score. A healthy credit utilization ratio (the amount of credit used versus the total available) can boost your credit profile.
Cons
- Higher interest rates. Revolving credit, especially credit cards, often has higher interest rates compared to installment loans. If you carry a balance, interest charges can accumulate quickly, increasing the cost of borrowing.
- Potential for debt accumulation. The ability to repeatedly borrow can lead to accumulating debt if not managed carefully. Paying only the minimum can lead to long-term debt and higher interest costs.
- Fees and charges. Some credit cards charge annual fees, which can add to the cost. Further, missing payments can result in late fees and damage your credit score.
- Variable terms. Interest rates can be variable, meaning they might increase over time, affecting the cost of borrowing.
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Installment loan vs revolving credit
Structure
In an installment loan, you receive a lump sum amount of money that is to be repaid through fixed amounts over a set period. Payments usually include both principal (the borrowed amount) and interest. On the other hand, a revolving credit will provide you with a maximum credit limit that you can borrow against, and you can withdraw funds up to this limit as needed. You can repay the borrowed amount at any time, and as you repay, your available credit is restored.
Payment schedule
Payments are consistent in amount and in frequency (e.g., monthly) for an installment loan. Because the payment amount and schedule are fixed, it’s easier to budget. Revolving credit, on the other hand has variable payments. Minimum payments are often required, but you can choose to pay more. Payments can vary based on the balance and you can adjust your payment amounts based on your financial situation.
Loan term
The installment loan term is predetermined, such as 12 months, 3 years, or 5 years and it ends when the final payment is made. On the other hand, a revolving credit is available for ongoing or recurring needs. As you repay, your credit limit is replenished, allowing you to borrow again.
Flexibility
There is limited flexibility in an instalment loan. Once you make a payment, you cannot re-borrow the amount unless you take out a new loan. Some loans allow you to pay off early without penalties. Revolving credit offers high flexibility and is ideal for managing cash flow and unexpected expenses. You have the freedom to borrow and repay multiple times. The flexibility can lead to accumulating debt if not managed carefully.
Interest rates
Installment loans often have lower interest rates or fixed interest rates compared to revolving credit and the total interest cost is known upfront. A revolving credit line will have higher interest rates, especially if you carry a balance from month to month. Interest is charged on the amount of credit that remains unpaid.
Examples
An installment loan could be a car loan, personal loan or mortgages. Examples of revolving credit include credit cards, personal line of credit and cash advances.
Choosing between the two
- For fixed needs. Installment loans are often better for specific, large expenses where you need a clear payment schedule (e.g., buying a car or consolidating debt).
- For flexibility. Revolving credit is suitable for managing ongoing expenses, emergencies, or when you need access to credit with varying amounts (e.g., credit cards for everyday purchases or a HELOC for home-related expenses).
Understanding these differences helps you choose the right type of credit based on your financial needs and goals.
FAQs
How do installment loans affect my credit score?
Making timely payments on an installment loan can positively impact your credit score. However, missing payments or defaulting can harm your score.
Can I pay off an installment loan early?
Many installment loans allow early repayment without penalties, but it's important to check the loan terms for any prepayment penalties or fees.
What are the risks of revolving credit?
Risks include high-interest rates, potential for accumulating debt, fees for late payments or exceeding the limit, and the impact of high credit utilization on your credit score.
How can I manage revolving credit responsibly?
To manage revolving credit responsibly, aim to pay off the balance in full each month, avoid carrying high balances, make payments on time, and monitor your credit utilization ratio.
What is a credit limit?
A credit limit is the maximum amount you can borrow on a revolving credit account. It’s set by the lender based on factors like your creditworthiness.
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The bottom line
The choice between installment loans and revolving credit depends on your financial needs. Installment loans offer predictability with fixed payments and terms, making them ideal for large, planned expenses or specific financial goals, often at lower or fixed interest rates. However, they lack flexibility once borrowed.
Revolving credit, such as credit cards, provides high flexibility and convenience for managing ongoing or unexpected expenses, with the ability to borrow and repay repeatedly. While it offers ease of access and potential rewards, it comes with higher interest rates and the risk of accumulating debt if not managed carefully. Balancing the benefits of each type based on your financial situation and goals is crucial for effective credit management.
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