Both revolving debt and installment loans allow you to take out credit, but they work differently. Here are some of the key differences.
Before borrowing money, it is important to understand exactly how your debts work, and one of the first things you need to know is whether it is revolving debt or an installment loan.
Installment loans are loans for a fixed amount that are repaid on a set schedule. On the other hand, with revolving debt, you are allowed to borrow up to a certain amount, but you can borrow as little or as much as you like until you reach your limit. When you pay it off, you can borrow more.
Let’s take a closer look at installment loans and revolving debt to better understand the key differences between them.
One email a day could save you thousands
Expert tips and tricks delivered to your inbox that can save you thousands of dollars. Register now for free access to our Personal Finance Boot Camp.
How borrowing works on revolving debt versus installment loans
Installment loans can have fixed interest rates, which means you know in advance exactly how much you will be paying per month and in total in interest. You can also have variable rates. If you opt for a variable installment loan, your interest rate is linked to a financial index (e.g. the base rate) and can fluctuate. While your payment amount can change on a floating rate loan, your repayment date is still set – your payment amount simply increases or decreases as your interest rate changes to ensure that you can repay the loan on time.
Most installment loans are paid out monthly. You know exactly when your debt will be paid off in advance, and if it is a fixed rate loan, you 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 are lines of credit for home equity loans and credit cards. With revolving debt, you are given a maximum credit limit, but you can only use a small portion of your credit line if you want. For example, if you get a $ 10,000 home equity line of credit, you can only borrow $ 1,000 of it initially. When you’ve paid back that $ 1,000, the credit will be available again.
Some revolving debts are perpetual, which means your line of credit can remain open indefinitely and you can borrow and repay your debt forever. This is the case with credit cards. In some cases, your line of credit may only be available to you for a limited time, such as: B. 10 years for a home equity line of credit.
With revolving debt, you don’t know beforehand what the total cost of borrowing will be or when you will pay back your debt. That’s because you can borrow and repay your loan and borrow and repay your loan over and over while your line of credit is open, with your payment and interest costs re-determined each time based on the amount borrowed. In many cases, a floating rate is also charged on revolving debt, which means that the cost of interest can change over time.
When can you access borrowed funds with revolving debt versus installment loans?
If you take out an installment loan, you will receive the entire loan amount in one sum when you take out the loan. When you take out a personal loan of $ 10,000, $ 10,000 will be deposited into your bank account or you will receive a check for $ 10,000. If you decide to borrow more, you’re unlucky – even if you’ve paid off almost all of your $ 10,000 balance. You would have to apply for a new loan to borrow more.
With revolving debt, you have a choice when to borrow money. You can borrow credit right after opening a credit card, waiting six months or years depending on what you want (although you may not have used your card for too long, it may be closed due to inactivity). As long as you have not fully exhausted your credit line, you also have the option of taking out loans again and again, especially if you repay what has already been borrowed.
Installment loans are usually best when you want to take out a loan to cover fixed costs, such as: B. for a car or other large purchase. If you know you need to borrow but it is difficult to predict when you will need the money or how much you will need, then revolving debt may make more sense.
This is how repayment works with revolving debt vs. installment loans
Installment loans have a predictable repayment schedule. You agree with your lender in advance how often and how much you will pay. When you have a fixed rate loan, your payment never changes. So if you borrowed for five years and your monthly payments started at $ 150 per month, they would still be $ 150 per month in five years.
Revolving debt payments depend on how much you’ve borrowed. If you haven’t used your credit line, you won’t pay anything. Typically, once you have taken out a loan, you pay off your revolving debt on a monthly basis. However, you can only pay a small part of the amount due. For example, if you have a credit card, your minimum payment can be either 2% of your balance or $ 10, whichever is lower.
If you only make minimum payments on revolving debt, it can take a long time to pay off your debt and you will pay a lot of interest over the life of the debt.
Now you know the difference between revolving debt and installment loans
Now you know the key differences between revolving loans and installment loans, including:
- This is how the loan works: With installment loans, you have the right to borrow a fixed amount and you can only access more money when you apply for a new loan. Revolving debt gives you a maximum credit limit and allows you to borrow as much or as little as you want. You can also borrow more by paying back what you’ve already borrowed.
- When accessing funds: When you take out an installment loan, you will receive the entire loan amount in advance. With revolving debt, when you were given a line of credit, you actually haven’t borrowed anything. As long as the credit line remains active, you can take out loans at any time.
- This is how the repayment works: Installment loans have a fixed repayment schedule and a fixed repayment date. Your monthly installments are calculated so that you pay off the loan on the specified date. Revolving loans allow you to make minimum payments while you borrow. And since you can borrow more by repaying what you already owed, there may not be a set date that you will be cleared of debt.
So that you get a loan or loan that makes sense for you.