Borrowing against credit is helpful – it lets us make big purchases and cover unexpected expenses while paying for it with future income. Misusing credit, however, can negatively impact your credit score and your future ability to borrow money when you need it.
Understanding the two types of credit is important to maintaining a healthy credit score. Do you know the difference between installment and revolving credit?
Installment credit is a loan of a fixed amount, granted on the condition of its repayment over a clearly defined payment schedule. The value of the loan is set at the time of approval and the amount you borrow won’t change over time.
Types of installment credit can include:
Creditors expect regularly scheduled payments, plus interest, to be made in installments until the amount owed is paid in full. For example, the average Canadian university graduate with $26,000 in student loans would be responsible for monthly payments of $275.77, given a fixed interest rate of 5% over 10 years. Over time, the interest would add up to $7,092.44 for a total of $33,092.55 repaid to end the credit cycle.
Installment credit can be easier to manage, given that the fixed recurring payments are predictable and easy to budget.
Revolving credit is a type of loan issued with a credit limit that you can borrow against. With revolving credit loans, you can continue to borrow as much as you like-as long it stays under the limit. Repaying a borrowed amount makes that amount available to be borrowed again at a later time.
Types of revolving credit include:
Revolving credit loans don’t involve a fixed end to the credit cycle. Creditors expect regular payments against the balance owed, made either in full or with minimum monthly payment, plus interest. Revolving credit’s flexibility comes at an additional cost – its interest rates can reach upwards of 19%.
For example, a $300 charge on your credit card with a limit of $1,500 would reduce your borrowable amount to $1,200. Paying off the $300 in full would restore the amount available to borrow to $1,500. Alternatively, a $10 minimum monthly payment on the $300 charge would result in an available credit of $1,210 and would incur interest charges on the $290 you still owe.
Revolving credit fluctuates and can be more difficult to budget, depending on expenses and spending habits.
A healthy credit report and score often include a mix of credit types. Having both installment and revolving credit accounts demonstrates to creditors that you’re able to manage numerous credit commitments. Regardless of the type of account, the leading aspect impacting your credit score is your ability to make payments on time.
When payments are made on time, installment credit can be considered to be less impactful to your credit score and a reliable way to build a good credit history. Missing regular installment credit payments could lower your credit score, could result in the creditor repossessing what you bought, and could stain your credit history for up to seven years.
Revolving credit, on the other hand, has the potential to further damage your credit score if you’re not careful. In addition to the payments made on time, a large portion of your credit score is calculated based on your credit utilization rate. Carrying a balance of over 30% of your available credit may lower your credit score and make it harder to get a loan.
Installment credit, like a car loan, is a fixed loan repaid over a set period of time. With revolving credit, like a credit card, you can borrow as much as you need under an approved limit – as long as you continue to make payments.
To maintain a healthy credit score when using a mix of installment and revolving credit, remember to:
The effort you put towards improving your credit score will ensure that you can borrow money when you need it most.
About The Author
Daniel Teo is a personal finance expert and travel writer for Urban Departures in Toronto. With a passion for financial literacy and a wanderlust that has brought him to over 30 countries, his stories reveal what can be achieved with good financial habits. Urban Departures has appeared in The Globe and Mail, the Toronto Star, CBC and on BNN. Connect with Daniel and Urban Departures on Instagram and Twitter.
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