Installment Vs Revolving Credit – The Difference in Time and Interest

The legal obligations of the parties to a credit transaction are defined in the credit agreement. In general, those agreements are one of two types: an installment or a revolving credit agreement.

Installment credit: these agreements typically define a one-time transaction, for a specific loan amount and interest rate that the borrower repays in scheduled payments for a set term. Payments are amortized so that the borrower pays equal payments over the life of the loan. As payments decrease the balance owed, the borrower cannot secure additional funds through that same credit agreement, for instance, up to the original loan value. Most secure debt, such as a home mortgage or auto loan, are transacted through an installment credit agreement.

Revolving credit: the term of a revolving credit agreement is not fixed; the borrow is only required to make a minimum payment each payment period. The borrower can also execute multiple transactions through a single agreement, as long as the total outstanding debt under the agreement does not exceed the available credit limit authorized by the lender. Credit cards are the most popular example of revolving credit agreements.

Credit cards are sold as a convenience to the consumer – they eliminate the need to carry cash and provide consumers a simple tool for tracking expenses. However, installment loans usually have lower interest rates and more favorable terms. While obtaining a credit card is a great first step to establishing credit, consumers need to also establish a pattern of discipline when using revolving credit because of its more onerous terms.

Under revolving credit agreements, more of the borrower’s monthly payment is applied towards interest and fees charged than to repaying the principal balance. Instead of a fixed term with equal payments that reduce the debt to zero over that term, revolving credit requires only a minimum payment each month that includes a finance charge that is based on the ending month’s balance and annual percentage rate.

For example, a typical car purchaser might finance an installment debt of $25,000 carrying a 10% interest rate. The loan could be repaid in 4 years at a cost of about $6,000 in interest. Compare that to a revolving debt of just $5,000, but carrying a 20% interest rate. If the borrower only paid the minimum payment, that balance would take about 24 years to repay at a cost of more than $24,000 in interest.


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