What is revolving debt and how does it differ from installment debt?

The information provided on this website does not, and is not intended to, act as legal, financial or credit advice. See Lexington Law’s editorial disclosure for more information.

Not all debts are created equal, and it’s important to understand how different types of debt can affect your credit. Two of the major debt types—revolving debt and installment debt—work in different ways, and learning the nuances of each can help you manage your debt and maintain healthier credit.

What is revolving debt and how does it work?

Revolving debt is any debt without a set loan amount that you can keep drawing from up to a certain point. Revolving accounts have an established credit limit, but you don’t have to follow a payment schedule or pay a fixed minimum amount each month.

The most common form of revolving debt is a credit card. With revolving credit, you have an established line of credit that you can draw on as often as you need to, so long as you don’t go over your limit. Your credit limit is determined based on your income, assets and credit history.

Here are the basics of revolving debt:

• Instead of making a fixed minimum payment each month, your payments are a percentage of how much you borrowed that month. This means your monthly payment rates can change.
• You aren’t obligated to pay off the balance each month, but you’ll be charged interest on whatever balance you still owe. Revolving credit—such as a credit card—often has high interest rates.
• As you pay down your balance, you can borrow more until you reach your credit limit. For example, if you reach your credit limit of $300, a payment of $100 will immediately allow you to borrow an additional $100.

Below are some benefits and drawbacks of revolving debt:

Pros:

• Flexibility: Access funds up to the credit limit.
• Build credit: Improve your credit with proper management.
• Rewards: Receive incentives like rewards programs and cash back.
• Emergency access: Have a financial safety net.

Cons:

• High interest rates: Increase your cost of borrowing.
• Overspending risk: Risk overspending, causing unmanageable debt.
• Credit score impact: Hurt your credit if you have high utilization rates or make late payments.
• Minimum payments: Prolong repayment and increase borrowing costs.

Types of revolving debt accounts

Some types of revolving debt are backed by your assets, while others are not. The most well-known form of revolving debt is a credit card, which is unsecured. A home equity line of credit is another form of revolving debt, which is secured by your home.

These are the most common examples of revolving debt:

Credit cards

A credit card allows you to use any available funds at any time, as long as you continue to make minimum payments and don’t go over your credit limit. Carrying a balance on a credit card subjects you to accruing interest rates, whereas paying in full by the due date listed on your statement allows you to avoid interest charges.

Home equity lines of credit (HELOCs)

HELOC funds are commonly used by homeowners who need to cover a large expense, such as a home remodel. How much you can borrow is based on the equity of your home, which also serves as collateral. You aren’t required to pay a specific balance each month, but making payments replenishes your available credit (similar to a credit card).

The main difference between HELOCs and credit cards is that you can only access a HELOC during a defined amount of time, known as the “draw period.” It typically lasts around five to 10 years, after which the debt must be paid back during a “repayment” period and funds can no longer be withdrawn. A HELOC usually has far lower interest rates than a credit card since it’s backed by an asset (your home).

Personal lines of credit

Very similar to a credit card, these are funds you can borrow as needed and repay immediately or over time. Personal lines of credit allow you to carry a balance that accrues interest as you continue to borrow. Interest rates are usually variable, so it’s tough to predict how much you’ll end up paying for what you borrow.

Lines of credit usually allow you to withdraw money in the form of a check or cash. If you need cash, a personal line of credit can be the more affordable option due to the high fees associated with credit card cash withdrawals. It’s also possible to receive a higher credit limit with a personal line.

Business lines of credit

Business lines of credit operate almost identically to personal lines of credit, except they’re used for business expenses. This type of revolving loan lets you access your funds as needed to finance continuous short-term purchases, such as inventory, equipment repair or filling in a gap in cash flow.

Should I be carrying revolving debt?

While revolving credit can certainly help you improve your credit, it requires careful attention to how you use it. If you have a habit of missing payments or using too much available credit, it might harm your credit more than it would help it. It’s also possible for lenders to make a mistake and inaccurately report a missed payment on a revolving debt account.

Here are some helpful questions to ask yourself if you’re thinking about building your credit with revolving debt:

• Do I need a large sum of money quickly? Maintaining low utilization is crucial for healthy credit. A personal loan with a fixed repayment timeline might be a better option if you need a large sum.
• Can I make timely payments? To preserve your credit, ensure you can consistently make on-time payments for revolving debt.
• What is my current credit history? Lenders may approve a revolving credit line with high interest rates if you have a poor credit history. Assess your credit history to avoid unfavorable borrowing terms.

What is installment debt?

Installment debt is a loan repaid through regularly scheduled payments or “installments.” Each installment payment includes the principal amount borrowed and interest, which is why they are commonly used for longer-term financing. The interest rate and repayment period can vary depending on the installment debt you use. There are different types of installment debt, each designed for specific purchases, like buying a new car or home, funding expenses associated with education or even consolidating revolving debt or making a personal purchase.

Using installment debt for big expenses can help build credit with a clear repayment schedule, though it often requires some collateral, and the payment terms are less flexible than revolving debt accounts.

Below are some benefits and drawbacks of installment debt:

Pros:

• Fixed payments: You have regular, predictable payments for the loan term.
• Clear repayment schedule: A set loan term allows for easier financial planning.
• Lower interest rates: These interest rates are often lower than those of revolving debt, reducing borrowing costs.
• Builds credit: Installment debt can positively impact your credit.

Cons:

• Lump sum borrowing: You cannot access additional funds once disbursed.
• Prepayment penalties: They may charge fees for early repayment.
• Less flexibility: You must make consistent payments over the entire loan term.
• Collateral risk: Installment debt may lead to asset loss in case of default.

Revolving vs. installment debt: key differences

The first and arguably most significant difference between revolving and installment debt is the payment structure. With revolving debt, like credit cards or personal lines of credit, you have some flexibility to borrow, repay and borrow again up to your credit limit.

On the other hand, installment debt like home or auto loans require fixed, regular payments over a specific period until the loan is fully repaid.

Another major difference is interest rates. Revolving debt typically carries higher interest rates, especially if your credit isn’t the best. Installment debt generally comes with lower interest rates.

It’s also worth double-checking whether or not your revolving or installment debt has variable interest. This means that the debt issuer can raise or lower your interest rates provided they give you notice as outlined in your contract.

Finally, the impact on your credit also differs between revolving and installment debt. Revolving debt affects your credit utilization ratio, a crucial factor in determining your credit score, while installment debt does not. We’ll get more into how each type of debt can affect your credit below.

How revolving debt and installment debt impact your credit

Revolving debt and installment debt both impact your credit score. Having a mix of different types of credit accounts is one way to build your credit score. Successfully managing multiple kinds of credit is a good indicator to lenders that you’re a responsible borrower.

While late payments of any kind will usually negatively impact your credit, revolving debt in the form of credit cards can look riskier to lenders. This is because, unlike installment credit, there’s no personal asset—like a house or a car—attached to it that can be repossessed if you don’t pay on time.

How revolving debt affects your credit

Credit bureaus consider credit card debt to be one of the most reliable indicators of your risk as a borrower. Since lines of credit are one of the most common forms of revolving debt, it’s important to understand the ramifications it can have on your credit.

Pay attention to these factors when managing revolving debt:

• Utilization ratio: Credit utilization significantly impacts your credit, so it’s better to keep your utilization ratio low if you can.
• On-time payments: Paying your bills on time can improve your credit, while late payments can hurt it.
• Number of accounts: A mix of different credit types can help, but having too many credit cards might raise concerns.
• Account age: Older accounts with a good payment history show responsible credit use and can help your credit.
• Credit inquiries: Applying for new credit cards frequently may lower your credit, as it indicates a higher risk.

How installment debt affects your credit

Installment debt is typically considered less risky than revolving debt since it’s secured by an asset that you wouldn’t want to lose—whether that’s a new home, your car or your college tuition. It’s also considered more stable, so it has lower interest rates and less of an impact on your credit.

Here are a few ways installment debt impacts your credit:

• Credit mix: Having different types of debt can improve your credit. Adding installment debt can help diversify your credit profile.
• Payment history: If you faithfully pay your installment debt each month for the agreed-upon loan term, your credit can substantially improve over time.
• Credit utilization ratio: Using an installment debt to pay off credit card balances can boost your credit. By paying off the credit card debt, you lower your utilization ratio.
• Hard inquiries: Shopping around for installment loans like mortgages and auto loans triggers hard inquiries that can lower your credit.

Lexington Law Firm can help you work to address questionable negative items that might be harming your credit. Since revolving debt can significantly impact your credit, make sure you address errors on your credit report as soon as possible.

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