When it comes to borrowing money, you have a lot of options. Some loans are created for a specific purpose, such as auto loans and mortgages. Others, including credit cards, give you more freedom in how you spend and even let you borrow money on a rolling basis.
Credit typically falls into one of two buckets: installment credit and revolving credit. Here’s a look at key differences between these two types, and what you need to know about applying and qualifying for installment credit.
Installment credit is a form of debt that has a set amount and payment period. Common forms of installment credit include mortgages, car loans, personal loans, and student loans.
When applying for installment credit (a.k.a. an installment loan), you’ll typically review the following terms:
Note that despite their similarities to other types of loans, payday loans do not fall into this category. This is because the lender usually requires that you pay back the loan in full after a short period, rather than in installments.
Installment credit works like this: Say you want to buy a car, fund your wedding, or cover another large expense. You can go to a bank and request a loan. In this case, assume you borrow $20,000 and promise to pay it back over six years with an interest rate of 3.99% APR.
For the length of your loan, you will have a monthly payment of $312.81. When you finish paying off your loan, you will have paid $2,522.50 in interest.
When it comes to revolving credit, think about how credit cards work. Most credit cards have a credit limit, which caps how much money you can owe at any given time. As long as you don’t reach your credit limit, you can keep borrowing money from the bank by using your credit card and paying the balance at the end of each month.
Further, on a credit card, your monthly payment is based on your current balance and there’s no predetermined payoff period. So you can keep borrowing money without having to go to the bank.
Different types of installment loans have different credit and income requirements. But in general, the better your credit, the better chances you have at getting approved with a good interest rate.
If you’re not sure what your credit score is, you can check it for free, such as through AnnualCreditReport.com.
Experian, a major credit bureau, lists the different FICO credit score ranges as follows:
If your credit score isn’t at least in the good range, you may still get approved for installment credit. However, you might not necessarily get a favorable interest rate.
To improve your credit score, review your credit report to see what needs work. Dispute errors you find and ensure all listed credit accounts are in good standing.
Your credit score isn’t the only factor lenders will consider, however. If you have high credit card balances or a lot of other debt, your debt-to-income ratio might be high. A high debt-to-income ratio can scare off lenders because they might think you can’t pay back all your debt.
The easiest way to get installment credit is through your local bank or credit union. Depending on your needs, though, you might want to shop around to get the best deal. You can find a good selection of personal loans online. And if you’re applying for a mortgage, a broker can give you more options.
If you’re buying a car, you can get an installment loan through your bank directly or through the dealership where you’re buying the car. Unlike your bank, the dealership can reach out to multiple lenders to find the best rate for you.
Make sure to read the fine print on an installment loan before signing. There, you’ll find any hidden costs or conditions. For example, some loans penalize you if you pay off the loan early. You’ll also want to understand what happens if you’re late on a payment or default.
According to FICO, your payment history is the most important factor in your credit score. As you make on-time payments, the lender reports that information to the three major credit bureaus: Equifax, Experian, and Transunion.
If you’re not careful, though, an installment loan can hurt your credit. Making late payments or defaulting on your loan, for example, will negatively impact your score.
If you borrow too much, the debt burden can also weigh on your credit score. How much you owe is the second most important factor in your credit score. Be sure to borrow only what you can easily afford to repay. Putting too much of your income toward debt will strain you financially and make it easier to start slipping on payments.
Installment credit is a common way to get the funds to buy something you need. But if you don’t have stellar credit or already have a lot of debt, you might not get approved for more. Before applying, work to build your credit and pay off your other debt first.
If you do it right, an installment loan can help you reach your financial goals. But sacrificing your financial security with high interest rates and a large debt load isn’t worth it.
Before applying for installment credit, take stock of your financial well-being and needs. Make a decision based on facts rather than emotions. You’ll be much better for it in the long run.