What Are the Different Types of Credit?

Credit represents a financial arrangement where one party, the borrower, receives resources such as money, goods, or services from a lender. This arrangement comes with a promise to repay the borrowed amount, typically alongside an additional charge, known as interest, at a future date. Understanding the various forms of credit is important for individuals to make informed decisions regarding their financial obligations and opportunities. Different types of credit products serve distinct financial needs and carry varying terms and conditions.

Revolving Credit

Revolving credit provides borrowers with a set credit limit that can be used repeatedly. As the borrowed amount is repaid, the available credit replenishes, allowing for continuous access to funds without needing to reapply for a new loan each time. Interest is charged on any outstanding balance, and borrowers are required to make at least a minimum payment each billing cycle. This structure offers flexibility in managing ongoing financial needs.

Credit cards are a common example of revolving credit, enabling consumers to make purchases up to an assigned limit. Interest rates, often expressed as APR, average 22% to 25% or higher. Minimum payments are calculated as a percentage of the outstanding balance, between 1% and 4%, plus any accrued interest and fees. Home Equity Lines of Credit (HELOCs) also function as revolving credit, allowing homeowners to borrow against their home equity. HELOCs feature variable interest rates tied to an index like the U.S. prime rate.

The available credit on a revolving account decreases with each new charge and increases with each payment made. This dynamic allows borrowers to manage their debt according to their cash flow, as long as they adhere to the minimum payment requirements. While providing convenience and financial adaptability, responsible management is necessary to avoid accumulating high interest charges.

Installment Credit

Installment credit involves borrowing a fixed sum of money that is repaid over a predetermined period through regular, scheduled payments. Each payment, known as an installment, includes both a portion of the principal amount borrowed and the accrued interest. Once the entire loan amount has been repaid, the account is closed, and no further funds can be accessed from that specific loan.

Mortgages are a primary example of installment credit, used to finance the purchase of real estate. These loans have long repayment terms, commonly 15 or 30 years, with interest rates that can be fixed or variable. The average 30-year fixed mortgage APR can range from 6.5% to 7%. Auto loans also fall into this category, with repayment periods ranging from three to seven years. Interest rates for new car loans average around 6.5% to 7% APR, while used car loans carry higher rates, averaging 11% to 12% APR.

Student loans represent another common type of installment credit, designed to finance educational expenses. Federal student loans have fixed interest rates, with current undergraduate rates around 6.4% APR and graduate rates around 7.9% APR. Private student loans can have fixed or variable rates, ranging from 3% to 18% APR. Personal loans, used for purposes like debt consolidation or home improvements, are also installment loans. These loans have shorter terms, one to seven years, and interest rates that can vary significantly, from 6% to 36% APR.

Secured Credit

Secured credit requires the borrower to pledge an asset as security for the loan. This collateral provides a guarantee to the lender, reducing their risk if the borrower fails to repay the debt. If the borrower defaults, the lender has the legal right to seize and sell the pledged asset to recover their losses. This risk reduction for the lender translates into more favorable terms for the borrower.

Due to the reduced risk, secured loans feature lower interest rates compared to unsecured loans, and borrowers may qualify for higher loan amounts or more flexible repayment terms. Mortgages are a prime example, where the home being purchased serves as the collateral for the loan. Similarly, with auto loans, the vehicle itself acts as collateral. If loan payments are not met, the lender can initiate foreclosure on a home or repossess a vehicle.

Secured credit cards also require collateral, in the form of a cash deposit held by the issuer. This deposit, ranging from $200 to $2,500, matches the credit limit provided on the card. Secured credit cards are used by individuals with limited or developing credit histories to build a positive credit record through responsible use and timely payments. The presence of collateral makes these credit products more accessible, but it also means the borrower risks losing the asset if they do not fulfill their repayment obligations.

Unsecured Credit

Unsecured credit does not require the borrower to provide collateral. Instead, lenders assess the borrower’s creditworthiness to determine eligibility and loan terms. Because there is no specific asset for the lender to seize if the borrower defaults, unsecured credit carries a higher risk for the lender. This increased risk is reflected in the terms offered to the borrower.

The absence of collateral leads to higher interest rates on unsecured loans compared to their secured counterparts. Lenders compensate for the increased risk by charging a premium. Eligibility requirements for unsecured credit can also be more stringent, necessitating a strong credit history.

Common examples of unsecured credit include credit cards, personal loans, and student loans. While some credit cards may be secured, the majority operate without a collateral requirement. Personal loans and student loans also fall into the unsecured category, providing funds. If a borrower fails to repay an unsecured debt, the lender cannot directly seize an asset. Instead, they may pursue other collection methods, such as engaging collection agencies or initiating legal action.