Installment Loans Vs. Revolving Credit: An Overview
Sarah Li Cain6-Minute Read
June 28, 2022
When it comes to borrowing money, there are several methods you can consider depending on your needs. Yes, you need to understand how credit affects what you can borrow, but knowing the difference between installment loans and revolving credit is important, too. That’s because these types of loans can affect your credit differently, and have different features that work better for different financial situation.
Installment Loans Vs. Revolving Credit: What’s The Difference?
With an installment loan, borrowers will receive the entire loan amount as a lump sum, which they’ll be required to make regular payments toward on a fixed schedule until the loan is paid off. Revolving credit gives a borrower a maximum credit limit to borrow from, repay and borrow from again as needed if they haven’t maxed out their line of credit.
Installment loans tend to be used for larger purchases like a home, where you only need to borrow money once. Revolving credit can be for smaller purchases, and for borrowers who want access to credit whenever they want.
With both types of loans, you may qualify for a variable or fixed interest rate, and the loan amount or credit limit you’ll be approved for will depend on factors such as your credit score and income.
What Are Installment Loans?
Installment credit – also known as installment debt – is a popular type of loan. Essentially, installment loans allow you to borrow a fixed amount of money and then make regular payments of a specific amount on the loan until you’ve paid it off. If you want to borrow more money, you have to apply for another loan.
Examples of installment type loans include car loans, mortgages, personal loans and student loans.
What Is Revolving Credit?
Revolving credit is marked by the ability to continue to borrow from a line of credit. You have an amount of money — typically called a credit line — from which you can borrow. You continue to borrow and pay interest on what you owe until you hit your credit limit, at which point you’ll need to pay down some of your debt to free up your credit line and continue borrowing.
The classic example for this type of credit is a credit card. With a credit card, you’re given a credit limit, or credit line. As long as you keep up with your payments and stay below your limit, you have credit available to you and can continue borrowing.
Another example of revolving credit is a home equity line of credit, or HELOC. This type of loan allows you to tap into your home equity and you can take out money in increments up to your credit limit. Unlike credit cards, you can only make withdrawals for a specified amount of time — afterwards you’ll need to pay your outstanding balance.
Loan proceeds given in one lump sum
Approved for a credit limit
Can only borrow from the loan once
Can borrow up to the credit limit anytime
Paid back in installments in predetermined increments
Paid back in increments whenever there is a balance
May be harder to qualify for
Interest may be higher
Interest charged on total amount borrowed
Interest charged on amount withdrawn
How Does Revolving Credit Affect My Credit?
It’s important to know about both of these types of credit and how you can make them work for you, as borrowing money and paying it back in a timely manner is part of how you build your credit history and establish a good credit score.
Although certain behaviors like making on-time payments affect all types of loans, here’s what specifically can impact your credit for revolving credit.
Credit Utilization Ratio
Your credit utilization ratio is expressed as a percentage and compares the balance in all your revolving credit accounts and your overall credit limit.
With revolving credit like a credit card, you have to keep an eye on your credit utilization ratio. After payment history, utilization is the second most important factor in determining your credit score.
The higher your credit utilization, the more your credit score could be affected negatively. That’s because having higher balances on your accounts shows lenders that you have a higher chance of being stretched too thin. In other words, the more money you owe, the more it could seem like you’ll have a hard time paying it back, hence you become riskier in the eyes of lenders.
To calculate your utilization ratio, start by looking at the amount of money you currently owe in revolving credit and dividing that by your total credit limit. For example, if you have one credit card with a limit of $2,000 and you currently owe $1,000, your utilization rate is 50%.
To avoid negatively affecting your credit score, experts recommend keeping your utilization below 30%.
Payment history is one of the most important factors affecting your credit score. If you’re unable to make on-time payments or any payments at all, your credit score is going to take a hit. Lenders will deem you a risky borrower, so you’re less likely to be approved for loans. Even if you do, you’ll probably be qualified for higher interest rates compared to a borrower who has excellent credit.
You can also end up getting caught in a cycle of debt, where you’re taking on more debt to try to pay off what you currently owe and the amount of interest you owe continues to grow until it’s out of control.
Whether your various credit accounts become more of a hindrance than a help comes down to whether you’re able to make on-time payments.
How Do Installment Loans Affect My Credit?
Although installment loans tend to appear more straightforward, there are still factors that you still need to be mindful of when it comes to how it affects your credit.
Debt-To-Income (DTI) Ratio
Your debt-to-income ratio, or DTI, is a percentage lenders look at to gauge whether you can afford a new loan. The higher this ratio, the more likely you’ll appear stretched too thin financially. It could either lead you to being approved for less than you’d expect, or not at all. For instance, mortgage lenders generally look for a DTI of less than 43%, though the lower yours is, the better.
To calculate your DTI, take the sum of all your minimum monthly payments for all the loans you owe money on — including car loans, student loans, credit cards and mortgages — and divide it by your gross monthly income.
For example, if you owe $500 for your car loan, $100 in student loans, and $1,200 for your mortgage, you owe a total of $1,800 each month. If your gross monthly income is $5,000, your DTI would be 36%.
Like with revolving credit, making on-time payments will help you build your credit score, and the opposite will negatively affect it. Considering payment history is one of the biggest factors that affects your credit score, you’ll want to make sure you’re making payments on time.
Missing payments doesn’t just hurt your credit. If you borrowed money to buy your house or your car, those assets are put at risk when you aren’t able to make payments on those loans. You could end up having your house foreclosed on or your car repossessed.
If you feel you’ll struggle with payments, you’ll want to make sure you speak with your current creditors to come up with ways you can make on-time payments. You may be able to come up with alternatives, like forbearance or a modified payment plan, to ensure your credit won’t be negatively affected.
The Bottom Line
Installment loans and revolving credit are used for different things. Installment credit like a car loan or a mortgage can make financial goals more achievable, while revolving credit can help you manage your finances by allowing for easier payments and offering better consumer protection than other forms of payment.
When used carefully, both types of loans can be great tools to help you build a good credit score, which unlocks the door to being able to buy a home one day. If you’re looking at purchasing a home soon, you’ll want to make sure your credit is in tip-top shape so that you’ll increase your chances of being approved for the best rates and terms.
One way to find the best rates for your credit profile is to take the time to build your credit score, as well as getting preapproved. You can find out what rates and terms you may qualify for — the best part is that it won’t affect your credit. See how much house you can afford with Rocket Mortgage®.
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