Installment Loans VS. Revolving Credit

09-Sep-2015

There are basically two kinds of credit: installment loans and revolving credit. Knowing the difference is important and using the right option in the right situation can save you a lot of time and money. We will explain the difference in detail so you can make better financial decisions.

Installment Loans:
We usually use installment loans to buy things such as homes and cars or bigger-ticket purchases over a predetermined repayment period. You take out installment loans for specified amounts, such as $2,500 for a specified amount of time to buy a used car or furniture, for example.
You know in advance how much your monthly payment will be and how long it will take to pay off the loan (also known as the "term of the loan"). As a result, installment loans are easy to work into your budget. They can also carry competitive rates, in the 17- to 28- percent range. Unlike credit cards, your rate will be the same for your entire loan and can-not be increased without re-contracting which requires your approval and signature.
When you begin paying back an installment loan, a portion of what you're paying is going toward the interest and the remainder toward the principle. Over time though, you continue to pay down an increasing portion of loan principal, too. This steady, increasing reduction of the principal amount is called amortization. You also, usually have the option of paying additional amounts toward the principle and this can lower the overall amount of interest you end up paying over the term of the loan. If you need to borrow additional funds during the loan repayment period, however, you must re-contract new terms of the loan or use some other form of credit.
There are two types of installment loans:
·    Secured loans are linked to some sort of collateral, such as a car, boat or home that the bank could confiscate and sell if you don't pay back your loan. They usually carry lower interest rates than unsecured loans.
·    Unsecured loans are riskier to a bank and therefore carry a higher interest rate. This loan hinges only on your good reputation: your credit score, payment history and job status, for instance.



Revolving Credit:
Revolving forms of credit (Credit Cards) are more open-ended than installment loans. Lines of credit and credit cards are both examples of revolving credit. In essence, revolving credit means you are given a set amount you may borrow (also known as your credit limit). As you pay back the money your credit limit "revolves" back up to what it was originally, say $2,000 or $5,000. You can dip into your pool of credit many times and for many purchases -- as long as you continue to pay the money back.
You pay a steep price for this flexibility, however. Revolving credit rates vary widely, depending on your credit and payment history, but can be range from 19 percent to more than 29.9 percent. And, card issuers reserve the right to increase your interest rate at any time if you don't pay your bill on time.
Revolving credit is popular today because it's easy and quick to get approved for it. Even folks with dinged credit histories are usually able to get credit cards. In addition, revolving forms of credit have much smaller required payments than installment loans. That's because your minimum monthly payment is based on only a small percentage (perhaps 2 percent) of your outstanding balance that particular month.
If you only pay the minimum, you could be paying your credit card company until you die, literally! Why? Because you're paying mostly interest, you’re not paying down the principal on the money you've borrowed. It can become a vicious circle that drags you into deeper debt. Self discipline is required but can be difficult to realize as you’re bombarded with credit card and credit line offers.
Conclusion:
If you're buying something less expensive and more temporary, such as back-to-school clothes for your child or a dinner and movie with someone, then revolving credit (such as a credit card) is fine. However, anything more than that, especially bigger ticket items absolutely puts the financial advantage on the installment side of the argument. An example: Consider the purchase of some furniture for $3,500. For the sake of comparison, assume that both a loan and a credit card carry the same interest rate (although that would be extremely unlikely). Here's what you'd pay:
 
                           Installment loan    Revolving credit       
Initial Balance       $3,500                        $3,500       
Interest Rate             10%                           10%       
Years to Repay           5                             *14.8       
Interest Cost         $961.88                   $1,638.54       
*Assumes that you pay only the required minimum payment (calculated as 2.5% of your balance) each month.