Fundamentally, there exist two different types of credit – revolving debt and installment debt. Within each type, the credit can be secured (backed by collateral such as property or an automobile) or unsecured (credit card debt is a common example), and installment loans often are secured. Regardless, the two types of credit function somewhat differently and have varying impacts on a credit score and profile.
What is revolving debt? A revolving line of credit broadly refers to a predetermined amount of available credit that is extended to an individual, small business or corporation that can be tapped into as needed, but never exceeded. Installment debt, on the other hand, broadly includes traditional loans such as home mortgages, auto loans and student loans, with funds earmarked for a specific purpose and a repayment schedule that includes defined amortized monthly payments. So, what are the differences and benefits when comparing revolving debt vs. installment debt? Let’s take a closer look.
Revolving vs. Installment Debt
What is installment debt vs. revolving debt? The nature of revolving debt implies that as the debt is periodically repaid, it can once again be borrowed up to its previously established credit limit. One of the more common examples of a revolving credit line is an unsecured credit card, although there are others. With a revolving credit line, a lender often grants a maximum credit line to an individual borrower who accesses funds for purchases, ongoing expenses or overdraft protection.
In the case of a small business, a revolving credit line can be useful for capital expansion or as a timely infusion of working capital. In either instance, interest expense accrues and is capitalized into the total obligation owed by the borrower. However, with consistent monthly payments, not only can interest expense be limited, but a lender often extends the amount of the revolving credit line as a track record of repayment is established. In all cases, the nature of revolving debt allows the debtor to borrow up to the amount of the credit limit as regular repayments are made, and the revolving credit line may be used repeatedly, provided that the maximum credit line is not exceeded.
Installment debt, on the other hand, often takes the form of traditional loans such as home mortgages, auto loans, and student loans – with a fixed amount of funds disbursed up front – the borrower does not have any freedom to decide when he may choose to receive additional incremental funds. There is also less flexibility offered to the borrower in terms of using the funds once an installment loan is granted.
For example, it’s not permissible to take money generated from an auto loan and utilize it for general home repairs. Installment debt comes with a defined repayment schedule involving a fixed or predictable monthly payment that is to be paid in full over a specified period of years. Revolving debt works differently than installment debt by offering greater flexibility in terms of timing and use of funds.
A revolving line of credit actually represents an ability to access funds at a future date to be chosen by the borrower, who also enjoys far greater flexibility in determining how to allocate the funds as compared to funds received via installment debt. In sum, money borrowed from a revolving credit line does not come with restrictions as to how it may be deployed – the borrower maintains complete flexibility as to how funds may be spent. Repayment becomes a function of the amount owed on the revolving credit line, with minimum monthly payments calculated as soon as the borrowing begins.
How to Get Out of Installment Loan Debt
One of the benefits of installment debt is that repayment involves a fixed, monthly amount that does not fluctuate in the manner that revolving debt minimum monthly payments do. With installment loan debt, the borrower is provided with a set monthly repayment amount for a defined period of time, and this makes budgeting easier. Installment loans can also be extended in duration, lowering monthly payments and making them more manageable.
Installment debt is often less expensive than revolving debt, with some secured installment loans carrying interest rates as low as the low single digits, ranging up toward 18% on the high end for unsecured installment loans. Meantime, revolving high-interest credit card debt averages 16% and frequently exceeds 20%. For this reason, many people pursue personal installment loans at lower interest rates as a form of debt consolidation to pay off higher interest rate revolving credit card debt. Generally, this is not a bad strategy – however there are some considerations and drawbacks.
When an individual accesses a personal installment loan, the process obviously concludes with the taking down of more debt. Therefore, especially in those instances when the installment debt has been taken out as a form of debt consolidation to pay off high interest rate revolving credit card debt, it is absolutely essential that the debtor maintains the self-discipline to allocate the additional borrowed funds toward the actual repayment of the revolving debt.
Anything less than that immediately translates into a higher debt load and greater monthly burden that places additional pressure on cash flow and a monthly budget. Furthermore, when it comes to getting out of installment loan debt, many lenders prefer that the borrower adhere strictly to the pre-set monthly repayment schedule – even if the debtor wishes to pay more than the monthly amount due. Therefore, it is not uncommon for prepayment penalties to be assessed on a borrower who seeks to get out of installment loan debt before the term of the loan comes up.
How Do Revolving Debt and Installment Debt Impact a Credit Score?
Let’s get to the question of how the two types of debt impact a credit score. How does revolving debt impact a credit score? The three major credit bureaus (Experian, Equifax and TransUnion) consider revolving debt the more significant of the two types, since the most common form of revolving debt is credit card debt. Apart from establishing a track record of timely monthly repayment, the credit utilization ratio (the percent of available debt that is actually borrowed) is an important component of a FICO score, and credit card debtors should aspire to keep this ratio below 30% at all times.
Credit card debt is considered a more reliable indicator than installment debt when predicting the potential risk of a borrower. The age of open revolving debt accounts (older accounts are better) also matters, as this can reflect a stable history of managing credit. Let’s turn to the next question – how does installment debt impact your credit score? Since installment debt is often secured by an asset (a house or car) that a borrower is naturally reluctant to lose, installment loans are considered safer by the credit bureaus and have less influence on a credit score as a result. That said, making timely monthly repayments on any type of installment debt remains crucial to building and preserving a healthy credit score and profile.
About the Author: Steven Brachman
Steven Brachman is the lead content provider for UnitedSettlement.com. A graduate of the University of Michigan with a B.A. in Economics, Steven spent several years as a registered representative in the securities industry before moving on to equity research and trading. He is also an experienced test-prep professional and admissions consultant to aspiring graduate business school students. In his spare time, Steven enjoys writing, reading, travel, music and fantasy sports.