Revolving and Installment Credit: What’s the Difference?
People may be created equal, but different types of credit are not. Let’s review the differences between revolving and installment credit so you can find the loan that’s right for you and your finances.
With revolving credit, you have access to a credit limit set by a lender. Revolving lines of credit can be used for personal use (generally, that’s how credit cards function), but businesses often borrow lines of credit as well to manage ongoing expenses.
You determine how much of that credit limit you will use and pay it off on a monthly basis. Revolving credit typically carries a variable interest rate and can change over time. Meanwhile, installment credit refers to an account where you borrow a set amount of money and agree to monthly payments of a set dollar amount until the loan is paid off.
- How revolving credit works
- How installment credit works
- The bottom line
How revolving credit works
If you have revolving credit (sometimes referred to as a revolving account), you’ll pay down a balance each month but are susceptible to paying more charges. Credit cards and home equity lines of credit (HELOCs) are examples of revolving credit.
The credit limit for revolving credit is established by the lender and can increase or decrease depending on the circumstances. Revolving credit has an interest rate that can fluctuate, so in some cases, your monthly payments may rise.
Although you can carry a balance on a revolving credit account past the payment date, it is financially prudent to pay off revolving debt in full each month. This option of carrying over credit is why it is referred to as revolving credit. In other words, you are “revolving” the balance when you carry it over to a new month.
Pros and cons of revolving credit
- Pro: You’ve got flexibility. You can choose if and when you want to use your credit and how quickly you pay your balance off in full.
- Pro: You can use it for pretty much anything you wish, once you’re approved for the line of credit.
- Con: Revolving credit carries variable interest rates typically, which means your rate can go up at any given moment. Some credit card issuers also charge annual fees and late payment fees.
- Con: If you continuously carry high balances relative to your total available credit limits, it can damage your credit score. Some 30% of your FICO Score is determined by this factor, called your utilization ratio.
- Con: Rates on lines of credit tend to be higher than rates you might receive on an installment loan like an auto loan or mortgage.
How revolving credit affects your credit score
- On-time payments can help. Using revolving credit to make purchases can help build your credit score, as long as you make your payments on time. After all, this is the biggest component of your credit score. But that also means you can really hurt your score by missing payments on revolving debt, so be careful to borrow only what you can afford to pay off.
- Low balances can improve your score; high balances could tank it. Ideally, you should try to keep your balances to less than 30% of your total available limit. For example, if you’ve got three credit cards with a total limit of $15,000, you should avoid carrying more than $5,000 across those three cards at one time. This is a significant factor in calculating your credit score, so going above that 30% threshold can really bruise your score.
- Older accounts can bolster your credit history. Credit scoring models reward folks who have longer credit histories. If you use revolving credit responsibly, you’ll help build a positive credit history.
How installment credit works
Types of installment loans you may be most familiar with are home mortgages and car loans. Installment loans have your back for life’s bigger expenses.
With an installment loan, you’re approved for a certain amount and issued the funds in one lump sum. Then, you pay the funds back over time in installments and typically have a fixed interest rate.
Pros and cons of installment credit
- Pro: Once you pay off an installment loan, it is considered closed, whereas a revolving account stays open.
- Pro: It diversifies your credit file to have a mix of both revolving and installment loan debt, so it’s good to have at least one installment loan with a positive payment history on the books.
- Con: Installment debt typically carries less weight than revolving debt in determining your credit score. This means it won’t have as large of a positive impact on your score as paying off revolving credit will.
- Con: While some installment loans like personal loans don’t require collateral, other types of installment loans might. You may have to use a home or car as collateral that can be used to recoup the lender’s losses if you don’t make a payment.
How installment credit affects credit scores
- If you pay an installment loan in full and on time, that loan will have a positive effect on your credit score.
- As with any type of debt, missing payments can seriously hurt your credit score, so be sure you can afford those monthly payments.
- A closed account in good standing will stay on your credit report for 10 years.
- Paying off an installment credit loan early is not likely to boost your credit score more than paying it off on schedule.
The bottom line
Revolving and installment credit are used for two very different purposes. Revolving credit is used as a shorter-term loan (like a credit card), whereas installment credit can be slowly paid off over the course of decades if needed, depending on the agreement (like with a mortgage). While they are very different forms of credit, both need to be paid on time in order to avoid negatively affecting your credit score.