Revolving debt and installment loans allow you to borrow, but they work differently. Here are some of the main differences. Image source: Getty Images.
Revolving debt and installment loans allow you to borrow, but they work differently. Here are some of the main differences.
Before you borrow money, it’s important to understand exactly how your debt will work, and one of the first things you need to know is whether it’s revolving debt or a loan. installment.
Installment loans are loans for a fixed amount that are repaid according to a set schedule. With revolving debt, on the other hand, you are allowed to borrow up to a certain amount, but you can borrow as little or as much as you want until you reach your limit. As you pay it back, you can borrow more.
Let’s take a closer look at installment loans and revolving debt to better understand the key differences between them.
How Borrowing on Revolving Debt Works vs. Installment Loans
Installment loans are made by banks, credit unions, and online lenders. Common examples of installment loans include mortgages, auto loans, and personal loans.
Installment loans can have fixed interest rates, which means you know exactly how much interest you’ll pay per month and in total. They can also have variable rates. If you choose a variable rate installment loan, your interest rate is linked to a financial index (like the prime rate) and can fluctuate. Although your payment amount may change with a variable rate loan, your repayment schedule is always fixed – your payment amount simply increases or decreases as your interest rate changes, allowing you to to repay the loan on time.
Most installment loans are paid monthly. You will know in advance exactly when your debt will be paid off and, if it is a fixed rate loan, you will also know the total cost of the loan. These loans are very predictable — there are no surprises.
Revolving debt works differently. Common examples of revolving debt include home equity lines of credit and credit cards. With revolving debt, you have a maximum borrowing limit, but you can choose to use only a small portion of your line of credit if you wish. If you have a $10,000 home equity line of credit, for example, you might initially only borrow $1,000. As you repay that $1,000, the credit becomes available to you again.
Some revolving debt is open-ended, meaning your line of credit can stay open indefinitely and you can borrow and pay off your debt forever. This is the case with credit cards. In some cases, your line of credit may only be available for a limited time, such as 10 years for a home equity line of credit.
With revolving debt, you don’t know in advance what the total cost of borrowing will be or when you’ll pay off your debt. In effect, you could borrow and repay your loan and borrow and repay your loan again and again while your line of credit is open, with your payment and interest charges being reassessed each time based on the amount borrowed. In many cases, revolving debt also imposes a variable interest rate, which means that interest charges can change over time.
When can you access borrowed funds on revolving debt versus installment loans?
When you take out an installment loan, you get the full amount you borrow in one lump sum when you take out the loan. If you took out a $10,000 personal loan, you would have $10,000 deposited in your bank account or you would receive a check for $10,000. If you decide you need to borrow more money, you’re out of luck, even if you’ve paid off most of your $10,000 balance. You would need to apply for a new loan to borrow more.
With revolving debt, you can choose when you borrow funds. You can borrow right after you open a credit card, wait six months, or wait years to borrow, depending on what you want (although if you don’t use your card for too long, it could be closed for inactivity). As long as you haven’t used up your entire line of credit, you also have the option of borrowing again and again, especially when you pay back what you’ve already borrowed.
Installment loans tend to be best when you want to borrow to cover a fixed cost, such as a car or other major purchase. If you know you’ll need to borrow, but it’s hard to predict when you’ll need the money or how much you’ll need, then revolving debt may make more sense.
How repayment for revolving debt works compared to installment loans
Installment loans come with a predictable repayment schedule. You agree from the start with your lender on the frequency of payment and the amount you will pay. If you have a fixed rate loan, your payment never changes. So if you borrow money for five years and your monthly payments start at $150 per month, in five years they will still be $150 per month.
Revolving debt payments depend on the amount you have borrowed. If you haven’t drawn on your line of credit, you won’t pay anything. Usually, when you have borrowed, you repay your revolving debt monthly. But, you may only pay a small portion of what is owed. When you have a credit card, for example, your minimum payment can be 2% of your balance or $10, whichever is lower.
If you’re only making minimum payments on revolving debt, it can take a long time to pay off what you owe, and you’ll pay a ton of interest over the life of the debt.
You now know the difference between revolving debt and installment loans
You now know the key differences between revolving debt and installment loans, including:
- How the loan works: With installment loans, you are allowed to borrow a fixed amount and you cannot access more money unless you apply for a new loan. With revolving debt, you get a maximum credit limit and can borrow as much or as little as you want. You can also borrow more as you repay what you have already borrowed.
- When you access funds: If you take out an installment loan, you get the full amount you borrowed up front. With revolving debt, you haven’t actually borrowed anything when you’re given a line of credit. You can borrow at any time as long as the line of credit remains active.
- How the refund works: Installment loans have a set repayment schedule and a set repayment date. Your monthly payments are calculated so that you repay the loan on the date indicated. With revolving credit, you can make minimum payments as you borrow. And, because you can borrow more as you pay off what you already owe, there may not be a specific date as to when you will be debt free.
You’ll need to decide what type of financing is right for your particular situation so you can get a loan or line of credit that’s right for you.
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