What Are the Different Types of Credit?

Credit is a fundamental aspect of personal finance, representing an agreement where a borrower receives funds or goods with a promise to repay the lender at a future date. This repayment typically includes interest and any applicable fees. Credit also encompasses an individual’s financial history, detailing their record of borrowing and consistent repayment. Lenders rely on this history, often summarized in a credit score, to assess a borrower’s ability and willingness to meet their financial obligations.

Revolving Credit

Revolving credit provides a borrower with access to a continuous line of credit up to a specified limit. This type of credit allows for repeated borrowing, repayment, and re-borrowing of funds as needed, as long as the account remains open and in good standing. The amount available for use fluctuates as balances are paid down or new charges are made.

Credit cards are the most common example of revolving credit, offering a preset credit limit that a cardholder can utilize for purchases. Interest is typically calculated on the outstanding balance, and while minimum payments are required, carrying a balance can result in significant interest charges. The average credit card interest rate in the U.S. has been around 20% to 24% recently, with rates varying based on creditworthiness.

Other forms of revolving credit include personal lines of credit and home equity lines of credit (HELOCs). These options allow individuals to draw funds as needed, repay, and then draw again. While some revolving credit, like HELOCs, can be secured by an asset, its defining characteristic is the ongoing, replenishable nature of the credit line.

Installment Credit

Installment credit involves borrowing a fixed sum of money that is repaid over a predetermined period through regular, equal payments. Unlike revolving credit, once the loan amount is disbursed, it cannot be re-borrowed without applying for a new loan. Each payment typically includes both principal and interest, and the loan account closes once the full amount is repaid.

Common examples of installment credit include mortgages, auto loans, personal loans, and student loans. These loans are often used for larger, one-time purchases, providing predictable monthly payments that help with budgeting. Mortgage terms commonly range from 15 to 30 years, while auto loans typically have terms between 24 and 84 months.

Interest rates for installment loans vary significantly based on the type of loan and the borrower’s credit profile. For instance, recent average interest rates for new car loans have been around 6-7%, while personal loan rates can range from approximately 6% to over 30%, depending on creditworthiness. Federal student loan rates are typically set annually and have recently ranged from about 6% to 9% for new loans.

Secured Credit

Secured credit is a type of credit arrangement backed by collateral, which is an asset pledged by the borrower to the lender as security for the loan. This collateral minimizes the risk for the lender, as they can seize and sell the asset to recover their losses if the borrower defaults on the loan. The presence of collateral often leads to more favorable loan terms for the borrower.

Borrowers may benefit from potentially lower interest rates and easier approval processes, especially if they have a limited or less-than-perfect credit history. Examples of assets used as collateral include real estate for mortgages, vehicles for auto loans, or cash deposits for secured credit cards. For instance, a secured credit card requires a cash deposit, often equal to the credit limit, which the issuer holds as security.

If a borrower fails to meet their payment obligations, the lender has the legal right to take possession of the pledged asset. This creates a strong incentive for the borrower to repay the loan as agreed.

Unsecured Credit

Unsecured credit is not backed by any specific asset or collateral. Instead, lenders extend credit based solely on the borrower’s creditworthiness, including their credit history, income, and overall financial stability. This type of credit carries a higher risk for lenders because there is no tangible asset to repossess in the event of default.

Due to the increased risk, unsecured credit typically comes with higher interest rates and stricter approval criteria compared to secured credit. Lenders rely on the borrower’s promise to pay and their demonstrated ability to manage debt responsibly. If a borrower defaults on an unsecured loan, the lender’s recourse is generally limited to legal action or engaging collection agencies, rather than seizing property.

Common examples of unsecured credit include standard credit cards, where no upfront deposit or collateral is required. Most personal loans and student loans are also unsecured, depending on the specific terms offered by the lender.