What Are the Two Main Types of Credit?

Credit is a financial arrangement where one party provides money or resources to another, with the understanding that the recipient will repay the amount later, typically with interest. This mechanism plays a significant role in personal finance, enabling individuals to make substantial purchases, manage unforeseen expenses, or smooth out cash flow. Understanding how this financial tool operates is a foundational element of financial literacy, impacting an individual’s ability to achieve various financial goals.

Revolving Credit

Revolving credit allows a borrower to repeatedly access and repay funds up to a pre-approved credit limit, with the available credit replenishing as payments are made. This type of credit offers flexibility, as borrowers can use varying amounts and repay at their own pace, provided minimum payment requirements are met. Lenders set the credit limit based on factors such as the applicant’s creditworthiness, income, and existing debt obligations.

Minimum payments on revolving credit accounts are calculated as a small percentage of the outstanding balance, often 1% to 3%, or a fixed small amount, whichever is greater. Interest accrues on the unpaid balance, usually calculated daily, leading to charges on any amount carried over from the previous billing cycle. Federal regulations require credit card issuers to provide at least 21 days between statement closing and payment due dates.

Common examples of revolving credit include credit cards, which offer a grace period before interest charges apply if the full balance is paid by the due date. Personal lines of credit provide flexible access to funds for various purposes, with lower interest rates than credit cards. Home equity lines of credit (HELOCs) allow homeowners to borrow against the equity in their homes, secured by the property.

Revolving credit is open-ended; the account remains active as long as the borrower makes payments and adheres to the terms, allowing for continuous borrowing and repayment. Payment amounts can vary significantly depending on the amount borrowed and the interest rate, providing flexibility but requiring careful management to avoid accumulating high interest charges.

Installment Credit

Installment credit involves borrowing a fixed sum of money repaid over a predetermined period through a series of regular, fixed payments. Once the total loan amount, along with any accrued interest, is repaid according to the agreed-upon schedule, the account is closed. This structure provides predictability, as borrowers know exactly how much to pay each month and for how long.

Installment credit involves a fixed loan amount and a fixed interest rate, expressed as an Annual Percentage Rate (APR). Each payment is applied to both the principal balance and the accrued interest, following an amortization schedule. This schedule details how much of each payment goes towards reducing the principal versus covering interest over the loan’s duration.

Common examples of installment credit include mortgages, used to finance real estate purchases with repayment terms of 15 to 30 years. Auto loans finance vehicle purchases, with terms ranging from 3 to 7 years. Student loans, used for educational expenses, can have extended repayment periods up to 25 years.

A defining characteristic of installment credit is the fixed payment amount, which remains consistent throughout the loan term, simplifying budgeting for the borrower. The repayment term is also set at the outset, providing a clear endpoint for the debt obligation. Unlike revolving credit, installment accounts close once the final payment is made, meaning the borrower cannot draw more funds from the same account without applying for a new loan.