Posted on Monday 22 June 2020
We all need to borrow money at some point in our lives. Whether it’s to finance a large purchase—like a house or a car—or to give a little extra breathing room in our monthly spending, loans and lines of credit are simply part of our unique financial portfolios.
And for most of us, borrowing money against an installment loan or a revolving credit line is the only way to make those big purchases possible. (Unless, of course, you’re lucky enough to be a multi-millionaire with zero money issues. If so, hats off to you—you are the exception to the rule!)
But installment loans and revolving credit lines also have another huge benefit. Aside from boosting our spending power, they also help shape our credit score, which impacts everything from your rental application to the interest rate on your loan. We need installment loans and revolving credit in our lives—but there are some crucial differences to consider. Before you sign up for one, you should know the difference between installment loans and revolving credit.
Don’t make the mistake of letting yourself sign up for the wrong type of loan. Keep reading to see the difference between installment loans and revolving credit—and most importantly, the advantages and disadvantages of both!
First, let’s talk about installment loans. What are they? These types of loans aren’t typically called “installment loans,” so you likely have a few of them already without even knowing it. Mortgages, auto loans, student loans, and personal loans are all examples of installment loans.
With an installment loan, you’ll have a regular repayment schedule with payment amounts (and interest rates) that are always the same. As long as you keep making your payments, your principal will gradually reduce over time and your loan will be paid off. Once your loan is paid in full, that’s it—you’re done with your payments and the loan expires.
Most installment loans are secured, which is an important distinction to make. There could be some significant consequences if you don’t fulfill your contract on a secured installment loan.
With a secured installment loan, you are entering into an agreement with the lender that says they can seize your property if you stop making payments.
For example, if you stop making payments on your car, it can be repossessed. If you stop making payments on your house, you’ll go into default and then foreclosure, where the lender essentially takes your house back from you and tries to resell it (yikes).
By and large, revolving credit represents one of the most common types of loans out there. What is revolving credit? Think of it as a constantly renewable loan—as you pay off your balance, you can continue to use any remaining credit that is available. And once the debt is repaid, your full loan amount automatically resets.
Credit cards are the best example of revolving credit: and in many ways, they are our favorite kind of loan. In 2016, 89 percent of Canadians had at least one credit card. And recent financial projections estimate that the average credit balance in Canada will increase to $4,465 by the end of 2020. Aside from traditional credit cards, you could also have a line of credit, like borrowing from a family member, a peer-to-peer lending site, or even a payday loan.
Revolving credit can either be secured or unsecured. An unsecured revolving credit account is typically most common, where you send in an application and you are automatically awarded a dollar amount that you can spend. Your only contribution is providing information on your income, credit score, and essentially agreeing that you will pay off whatever you spend.
With a secured revolving credit account, however, your line of credit is determined by what you contribute. You are directly funding your own spending amount (sort of like a debit card), and in this scenario, you can only spend what you have actually put into your line of credit. Secured credit cards are typically “bad credit” cards—if you have a low credit score and need to rebuild your credit or establish credit history, you’ll likely need to take out a secured credit card.
Revolving credit is not issued in standard, predetermined amounts. The spending limit that you receive will be unique to you, and is based on factors such as income, credit score, borrowing history, current debt-to-income ratio, etc.
We tend to look at “debt” as a scary, unmentionable four-letter word. But debt is a natural part of our financial lives, and in many cases, it’s necessary in order to keep our monthly budget going strong. And let’s be honest, the larger purchases—like a house or a car—would hardly be feasible without access to some type of loan or credit.
Before you take out an installment loan or a revolving credit account, make sure you understand exactly what you are getting into, the terms, and the unique advantages and disadvantages of each option. Don’t forget that many types of loans are designed to be long-term commitments, so you’ll want to be absolutely sure that you are making the best possible choice for your financial health!