Are personal loans installment or revolving credit?
If you need extra cash to cover unexpected expenses or make a significant purchase, you've probably come across two personal loan options: installment and revolving credit.
Personal loans can be either, depending on the lender or the type of loan. And like other financial considerations, your best choice depends on your personal circumstances and goals.
Here's an overview of each.
Installment loans vs. revolving credit personal loans
While both of these types of loans allow you to borrow money, they differ in terms of repayment structure, interest rates, flexibility, and risk.
What is an installment loan?
An installment loan is a credit account that provides a lump sum of money to be paid off over time in equal monthly payments that include principal and interest.
After fully paying off the loan, it's considered closed. If you need more funds in the future, you'll have to apply for a new loan. Standard installment loans include mortgages, vehicles, and personal loans.
Installment loans provide borrowers with manageable payments over periods ranging from two to 10 years (or up to 30 years for mortgages). For lenders, this translates to higher interest earnings over time.
Some lenders also let you choose between fixed or variable interest rates. Opting for a fixed rate eliminates the possibility you'll be faced with interest rate increases.
But if you are willing to take on some risk and the possibility of saving money if interest rates decrease, a variable interest rate might be more suitable for you.
Secured vs. unsecured installment loans
A secured installment loan requires collateral, such as your vehicle, home, or savings, as a guarantee for the lender. Failure to repay the loan can result in the lender taking possession of your assets.
Collateral reduces the lender's risk, partly because secured loans have longer repayment terms and lower interest rates. These loans are solid options if your credit score is on the low side.
An unsecured loan does not require collateral. Therefore, the interest rates are higher because there's little protection for the lender if you default.
Lenders decide if you are a good candidate for an unsecured loan by reviewing your credit score and ability to comfortably make the required monthly payments.
This includes assessing your debt-to-income (DTI) ratio to determine your available disposable income. The less debt you have in relation to your disposable income, the more you can borrow.
What is a revolving credit loan?
A revolving line of credit provides continuous access to a predetermined credit limit. You can use and repay the credit as needed if you make regular minimum payments and stay within the total loan limit.
Unlike an installment loan, the monthly amount you pay back varies based on your outstanding balance. Common types of revolving credit loans include credit cards, personal lines of credit, and home equity lines of credit (HELOCs).
Revolving credit loans typically come with variable interest rates to manage risk so lenders can adjust interest rates based on market conditions.
With this kind of loan, you can choose how much you want to spend each month, but overspending is tempting. Because there isn’t a predetermined payment schedule, managing and paying off your balance promptly and actively is essential to maintaining your financial well-being.
Choosing between installment loans and revolving credit personal loans
The type of loan you select will be influenced by your borrowing objective, the required credit score, payment structure (fixed or minimum), and potential credit score implications.
Credit score requirements
Installment loans usually require a minimum credit score of 580-640, depending on the lender. In comparison, revolving credit loans have higher requirements of 690-720.
This is because revolving credit loans carry a higher risk for debt accumulation and missed payments, and as previously mentioned, they are not backed by collateral.
Fixed payments vs. minimum payments
While installment loans provide a structured payment plan and a clear timeline for debt repayment, revolving loans have lower minimum payments, which may significantly lengthen the payback period.
Opting to pay only the minimum amount on a revolving credit loan can result in most of your payment going toward interest, so you should always make higher payments to clear debt quickly.
Credit score impact
Taking out an installment loan and consistently making timely payments will positively affect your credit score because it shows your ability to manage a larger loan over a prolonged period of time.
Conversely, a revolving credit loan may have a less predictable impact on your credit score because it fluctuates depending on your credit utilization. Maxing out your credit limit and continuously carrying a high balance can make it more challenging to qualify for future loans.
Scenarios in which each loan is more suitable
An installment loan may be better for you if:
- You need a single lump sum for a big purchase like a car, education costs, home improvements, appliances, or debt consolidation
- You have a fixed budget you can't afford to go over
- You want to build or improve your credit score
Alternatively, you may prefer a revolving credit loan if:
- You need to borrow a smaller amount of money to pay short term unexpected expenses such as medical bills or minor vehicle repairs
- Your income fluctuates, and you'd prefer to have flexible repayments
- You're interested in reward programs offered by some revolving credit cards
An aside: Did you know that having a mix of installment and revolving debt on your credit report can positively impact your credit score?
Your credit mix, which refers to the variety of debts you hold, accounts for 10% of your credit report.
Maintaining both types of loans demonstrates to lenders that you can responsibly manage various forms of debt. That's not to imply you should get into debt for no good reason, but rather that strategic debt diversification could work in your favor.
Final considerations: personal loan installments vs. revolving credit loans
In summary, installment loans are best for planned large purchases. Revolving credit loans are better suited for smaller, unforeseen expenses.
Don't fret if you are unsure about which loan option is best for you. Consult a financial advisor if you are worried about your credit score and overall financial stability.
If you are burdened by increasing debt, a debt counselor can offer valuable advice and assistance. Remember, there are professionals ready to assist you in improving and managing your financial health.