What Are the 3 Main Types of Credit?
Unpack the three primary categories of credit. Gain essential insights into how each credit structure operates for smarter financial choices.
Credit represents a financial agreement where one party, the borrower, receives something of value, such as money, goods, or services, from a lender with the promise of future repayment. This repayment typically includes interest charged by the lender for the use of their funds. Consumers in the United States commonly encounter three primary types of credit in their financial lives.
Revolving Credit
Revolving credit provides borrowers with access to a continuous line of credit up to a predetermined limit. This type of credit allows funds to be borrowed, repaid, and then borrowed again repeatedly, as long as the account remains in good standing. For example, if a credit card has a $5,000 limit and $1,000 is spent, $4,000 remains available; upon repaying the $1,000, the full $5,000 limit becomes accessible again.
Interest on revolving credit is calculated daily on the outstanding balance, not on the entire credit limit. Borrowers are required to make at least a minimum monthly payment, which is a percentage of the outstanding balance. Carrying a balance forward incurs interest charges, which are higher than those for other credit forms like installment loans. Common examples of revolving credit include credit cards, personal lines of credit, and home equity lines of credit (HELOCs).
Credit cards are a common form of revolving credit, offering flexible spending for everyday purchases. Personal lines of credit provide access to funds via checks or transfers, while HELOCs allow borrowing against the equity built in a home. The interest rates on revolving credit are variable, meaning they can change based on market conditions or the borrower’s credit score.
Installment Credit
Installment credit involves borrowing a fixed sum of money that is repaid over a specific period through a set number of regular, fixed, monthly payments. Once the initial lump sum is disbursed, the loan amount does not replenish as payments are made. The loan agreement outlines the total amount borrowed, the interest rate, and the precise repayment schedule, including the amount of each payment and the loan’s duration.
The account is closed once the entire loan, including all interest, has been fully repaid. If a borrower needs additional funds after paying off an installment loan, a new application process for a separate loan is required. Interest rates for installment loans are fixed, providing predictable monthly payments throughout the loan term, though variable rates are also possible.
Common examples of installment credit include mortgages for purchasing a home, auto loans for vehicles, student loans for educational expenses, and personal loans used for various purposes like debt consolidation or unexpected bills. These loans are used for larger, one-time expenses due to their structured repayment and lower interest rates compared to revolving credit. Making consistent, on-time payments on installment loans can positively influence a borrower’s credit history.
Open Credit
Open credit, sometimes referred to as charge accounts, requires the full outstanding balance to be paid by the end of each billing cycle. Unlike revolving credit, which allows balances to be carried over with interest, open credit does not charge interest if the balance is paid in full by the due date. If the balance is not paid in full, significant late fees may be incurred, and the account could be suspended or closed.
These accounts operate with a “no preset spending limit,” which means there isn’t a fixed maximum amount like a traditional credit card. Instead, the spending capacity can fluctuate based on the cardholder’s payment history, income, and overall creditworthiness. While this offers flexibility for large purchases, it does not equate to unlimited spending, as an internal limit is still determined by the issuer.
Examples of open credit include charge cards, such as American Express Green, Gold, or Platinum cards, which require monthly full payment. Utility accounts, like electricity or water bills, and medical bills also function similarly, where a service is provided, and payment for the full amount is expected by a specified due date. This type of credit is distinct because it prioritizes full monthly repayment, discouraging the accumulation of debt.