There are two main types of credit accounts: revolving credit and installment credit. When it comes to revolving credit, think credit cards. When it comes to installment credit, think mortgages or personal loans.
Our guide covers the ins and outs of installment credit: what it is, how it works, how it affects your credit score and if it’s a good option for you.
Installment Credit, Explained
Installment credit (aka an installment loan) is a loan you make fixed payments on over a set period until the loan is paid off. Installment loans come with an interest rate (fixed or variable), applicable fees (late fees or origination fees) and a repayment plan that schedules your monthly payments (aka installments).
Installment credit is different from revolving credit. Revolving credit doesn’t provide a lump sum of money that you pay back in monthly installments. A revolving credit account is a line of credit that has a predetermined maximum credit limit you can borrow from up to your limit. You can repay your entire balance at the end of the month or make the minimum monthly payment.
Revolving credit is a lot more flexible than installment credit, but installment loans usually allow you to make larger purchases.
Some common types of installment credit are:
- Mortgage loans: Mortgage loans are used to buy homes. The loans typically come in 10-, 15- and 30-year repayment periods and their interest rates can be fixed or variable.
- Personal loans: Personal loans can be taken out for a variety of reasons. The repayment period on personal loans depends on how much you borrow but is generally around 2 – 5 years. The interest rates on personal loans can be fixed or variable.
- Student loans: Student loans pay for higher education or career programs. Student loans typically come with a standard 10-year repayment plan, but this can vary based on the loan. Federal loans have fixed interest rates. Private loans can have fixed or variable interest rates.
- Auto loans: If you need money to buy a car, you take out an auto loan. The repayment period on auto loans can range from 3 – 6 years, and the interest rate is fixed.
Secured loans are installments loans backed by collateral (think: homes, cars, stocks, etc.) The lender can seize and sell the collateral if you miss payments.
How Installment Credit Affects Your Credit Score
The relationship between your credit score and your installment loan is a two-way street. Your credit score affects your ability to be approved for an installment loan, and it’s one factor that can influence your loan’s interest rate and loan repayment terms.
On the other side of the street is your installment loan. An installment loan can do one of two things: boost your credit score and credit mix (aka credit diversity) or lower your score if you consistently make late payments.
Installment credit can affect your credit score because of:
- On-time payments: On-time payments on your installment loan(s) can help you build and maintain a good credit score. Thirty-five percent of your credit score is based on your payment history, so missing payments can negatively affect your score.
- Paying it off: Paying off your loan with your account in good standing positively impacts your credit score for up to 10 years.
To make on-time payments, and ultimately, pay off your loan, make sure you can afford the loan first. Defaulting (aka missing payments) will likely drop your credit score. When it comes to loans, you should only apply for them when you need them, and/or you’re prepared to repay them.
If you think paying off your installment loan early will boost your credit score more than paying it off on schedule – that’s generally not the case.
Pros and Cons of Installment Credit
When it comes time to decide if you want an installment loan, it’ll help if you know its benefits and drawbacks. Knowing the pros and cons of installment loans might even steer you to revolving credit because you’ve decided it would be the better option.
Benefits of installment credit
- Lower interest rates: The interest rates on installment credit are generally lower than the interest rates on revolving credit. Because of the higher interest rates on revolving credit, any balance you carry over (aka revolve) to the next month will get more expensive because interest gets added to the remaining balance.
- Predictable payments: Installment credit is paid off with fixed monthly payments, which can help with budgeting. The monthly payment amount on revolving credit usually changes because it depends on how much credit you’ve used, which can make it harder to budget.
- Larger loan amounts: Installment loans have larger dollar amounts than revolving credit accounts. If you want to make a large purchase or investment (think: thousands to hundreds of thousands of dollars), you’ll likely need to do it with installment credit.
Drawbacks of installment credit
- Stricter qualifications: Installment credit lenders usually have stricter qualification requirements than revolving credit lenders when it comes to your income, credit history and outstanding debt.
- Limited loan uses: There aren’t many restrictions on use with revolving credit. Installment credit is typically used for a specific purchase or purpose.
- Potential high fees: There are typically a lot of fees involved with installment loans, including loan origination fees, application fees, legal fees, late fees or prepayment penalty fees (a fee for paying off your loan early).
- Inflexible repayment terms: Some lenders won’t let you change your loan terms once they’re set. Refinancing or debt consolidation may be your only options to get new loan repayment terms.
With Great Credit Comes Great Responsibility
If you want to use credit to make your purchases, your main options are installment credit or revolving credit.
Installment credit can help you make large purchases, and you repay it in a more predictable way than revolving credit. Your credit score affects the installment loan terms you qualify for. Your loan payment history will affect your credit score.
The key is to know your budget. Make sure you can afford your payments and can make them on time because with great credit comes great responsibility.