Installment Credit vs. Revolving Credit: Options When You Need to Borrow Money
There are many reasons you’ll need to borrow money during your lifetime. Maybe you’re buying a car, heading off to college, or becoming a homeowner. Though, we can’t forget the not so happy times that always seem to pop up when you don’t want them happening, like job loss, a medical emergency, or divorce.
Life happens. But before you get caught up in overspending and find yourself in overly expensive debt, it’s important to understand your options. What is installment credit vs. revolving credit, and when does it make sense to use each option? Understanding their benefits and their differences can help you manage your debt smarter and more efficiently.
What is installment credit?
Non-revolving, secured, or installment credit is typically a long-term, high-value loan that is borrowed. Think student loans, mortgages, car loans, or personal loans. The bank pays for what you need (car, house, etc.), and you’re expected to pay them back each month — a fixed amount, with interest.
Now before you let the word “interest” scare you, it’s important to know that installment credit options tend to come with lower interest rates compared to revolving loans. Because collateral is often involved, they’re a lower risk.
Why use installment loans?
Let’s forget about the obvious mortgages and car loans for a moment, and consider personal loans. What are the advantages of a personal loan as an installment credit?
Well, a key benefit of installment loans is that they have a fixed monthly payment, so they’re easy to manage. So if you need a large lump sum of money for an unplanned expense or large ticket purchase, they make a great, low-interest option to consider.
What is revolving credit?
Revolving credit, on the other hand, is a line of credit that you have access to, up to a certain amount. Think credit cards and home equity lines of credit (HELOCs). They’re considered “revolving” because you have the option to carry your balance over to a new month, rather than paying it off entirely. Because you are “carrying it over,” you are essentially “revolving” your debt.
It’s important to know, when you revolve a balance, you still have to make a minimum payment each month. This may be a fixed amount or a percentage of your total balance. Just keep in mind you’ll be charged interest on the amount that’s carried over. So if at all possible, you’ll want to pay most of — if not the entire — balance to avoid unnecessary interest charges.
Why use revolving credit?
The simple answer is that revolving credit should be used to fund smaller debts, as in anything under $15,000 (or less than that depending on your card available balance).
I think we all can agree that credit cards are incredibly convenient, which is another valid reason to use them. You don’t have to call a lender and apply for a loan, wait some time, and hope to be approved. Instead, credit cards offer online applications with instant approval, or at most within minutes of applying.
Just be sure, again, that you are paying attention to your balance. The last thing you want to do is revolve too much debt from month to month, which can result in higher interest payments. That’s an easy way to waste your money.
Which debt should you pay down first?
Let’s say you have a healthy mix of both installment and revolving credit. How do you prioritize which debt receives the higher payment?
As we mentioned above, revolving credit carries interest rates that are higher than installment accounts. Even though your revolving debt balance is likely much lower than a loan balance, the high-interest rates you’re paying can really add up fast. To find out for yourself, enter your balance information into a credit card payment calculator.
Let’s consider an example. Say you have a $7,500 balance on a card with a 14% APR. That means you’ll be looking at almost $1,800 in interest payments. That number alone could almost pay one month’s worth of mortgage payments (depending on where you live).
The bottom line: when it’s possible, do what you can to pay down revolving debt first.
Does it make sense to consolidate debt?
Some people are in a healthy financial position and just want to pay off debt faster. Maybe being debt-free is a resolution for this year. What can you do to achieve that goal sooner than later?
On the other hand, there are people experiencing hardships. Maybe it’s an unexpected medical bill, or many bills piling up. Perhaps you’re dealing with job loss. How can you pay debts while you’re unemployed? Are there options that can help you get through, so you’re not overpaying interest?
Should you take out an installment loan or use revolving credit? Take advantage of both? Whether times are good or bad, consolidating multiple debts into one manageable monthly payment can be an easy way to get out of debt sooner. So, yes, it may be a good idea to consolidate your debt.
Here are a few popular options that can make debt repayment faster and less expensive.
Credit card balance transfers
This revolving credit option is a rather fast and easy way to pay down debt, so long as you’re moving your balance to a card that offers 0% APR for a healthy amount of time. If you can secure a 0% APR rate for a year to 18 months, that should allow you enough time to catch up on debt payments. If you’re limited to only six months, you’ll need to take a long, hard look at your balance. It’s crucial to understand whether or not you can pay off that debt within six months. If you can’t, you’ll be hit with a much higher interest rate, and that defeats the purpose of transferring your balance.
A good rule of thumb is to only choose a credit card balance transfer if your debt is under $5,000. Anything more than that, you should consider an installment loan.
Prefer an installment loan option? If you’re a homeowner with significant debt, you may be interested in a mortgage refinance to consolidate that debt or pay it off entirely. Unlike a rate and term refinance, you can do what’s called a cash-out refinance, where you access your home equity as cash to pay off your high-interest debts. It’s a solid solution since you’re paying far less in interest compared to what you pay with credit cards or revolving credit. However, there are requirements you must meet to be eligible for debt consolidation.
For example, when refinancing to access cash, your loan may not exceed a maximum loan-to-value ratio or LTV. That means your total home debt can't exceed a certain percentage of the value of your home. Most loan programs typically allow you to cash out up to 80% of your property value. Though government loans have different requirements. The FHA allows 85%, and the VA allows 100%.
To calculate your LTV, follow this formula: Current Loan Balance ÷ Current Appraised Value = LTV.
Interested in additional debt payment options? Check out our article, Debt Management: Which Program is Best for Me?
Which option is better for my credit score?
Let’s face it — your credit score is a big deal. When you need to borrow money, you need to have some exceptional scores behind your name to ensure you get the best rates and offers. So what can you do today to set your future “borrowing” self up for success?
Consider diversifying your credit mix. Take the time to review how much you spend on revolving vs. installment credit. You want to be sure you’re not putting all of your eggs in one basket because the more diversified your credit is, the stronger your score can be.
You see, it’s not just about how well you pay down your debts. There are other factors that make a difference on your score. In fact, the “types of credit” you have in your name make up 10% of your credit score.
Let’s consider another example. Say you have three credit cards, all of which you manage well — keeping minimum balances and monthly payments are always made on time. Now, maybe you require money to pay for a home remodel or renovation project. While you could probably charge a lot of the project on your cards, it may be in your best interest to choose a home equity loan or a personal loan instead. Doing this can help you build your credit score and history. Plus, you’ll likely pay less in interest.
Just remember, you should never feel obligated to open a new line of credit if you do not need the money. The benefits of credit diversification are not enough to make a significant difference.
Manage finances smarter
Whether your goal is to borrow money smarter, spend less on interest, make it through some tough times, pay off debt faster, or build your credit, you have many options available to you. But before you spend or borrow money, think of how your choice of financing may affect you. Do what you can to establish a healthy mix of installment credit vs. revolving credit. Doing so will make it easier to manage your finances, and it can really help set you up for success.