When it comes to managing your money, consumer credit plays a big role. Credit can help you make purchases when you're low on cash, access funds in a pinch, stay on top of expenses and even earn perks and rewards. There are three main types of consumer credit:
- Revolving credit
- Installment credit
- Open credit
Each type is different, and can help you in a different way. So let's break down the similarities and differences so you know what best to use and when.
Revolving credit is a type of borrowing that helps you make purchases or cash withdrawals within a predetermined credit limit. Think of it as an open tab where you can keep ordering (until you hit your credit limit)—and as you pay off your balance the credit becomes available again, in an endless cycle.
One of the best things about revolving credit is its flexibility: you can use as much or as little of your available credit as you need at any given time; and you can repay some or all of your balance immediately or carry it for a longer period and just make regular minimum payments.
It's important to make at least the minimum payment on your revolving credit accounts by the deadline provided, or it will lower your credit score. Also, be mindful of your credit utilization ratio—the amount of credit you're using compared to the total amount you're allowed to use. Using more than 30% of the total credit available to you can negatively affect credit scores.
- Credit Cards: Issued by banks, stores or other lenders, credit cards are one of the most common types of revolving credit. You can use them for purchases, bill payments or cash advances. Credit card and store card issuers charge interest on unpaid balances, but you can usually avoid these charges by paying down your full balance by the due date each month. Some cards have an annual fee while others don't. Many offer rewards programs that provide cash back, travel miles, or points for eligible purchases.
- Personal Lines of Credit: This type of revolving credit is similar to a credit card, in that you can draw and repay funds on it as needed, up to your credit limit. Unlike credit cards, however, there's no bypassing interest charges when you use a line of credit, since interest starts accruing immediately on borrowed amounts until they are repaid. On the plus side, lines of credit typically have lower interest rates than credit cards, making them a smart choice for emergency expenses or large purchases that you plan to pay off over a longer period.
- Home Equity Lines of Credit (HELOC): As the name implies, a HELOC is a type of revolving credit that lets you borrow against a home's equity. It's like tapping into your home's piggy bank for things like home improvements, debt consolidation, or education. As a secured line of credit, HELOCs typically come with competitive interest rates but, and this is important, your home is on the line as collateral.
With installment credit, you receive a lump sum of money upfront and agree to pay it back over a set period, usually with fixed monthly payments. The key feature of installment credit is that the debt is fully repaid by the end of the term, unlike revolving credit, where balances can carry forward. But, just like with revolving credit, your payment history is reported, so be sure to pay your installments on time to maintain a good credit score.
- Car Loans: Car loans are a common example of installment credit. You borrow a lump sum, buy the vehicle, and then make regular, fixed payments over a set period, often three to seven years. Interest rates can be fixed or variable, depending on the loan terms and lender.
- Student Loans: With federal and private options available, these installment loans help borrowers finance their education. They typically offer competitive interest rates, and some even offer income-driven repayment plans, relieving the pressure of substantial student debt.
- Personal Loans: These loans can be used for various purposes, such as debt consolidation, home improvement, or unexpected expenses. Borrowers receive a lump sum and repay it over a specified term at a fixed interest rate.
- Mortgages: Mortgages are long-term installment loans that are used for buying real estate. They can have fixed or adjustable interest rates and repayment terms that extend over 15, 20 or 30 years. The property itself usually serves as collateral, so interest rates are typically better than on unsecured loans.
- Buy Now Pay Later (BNPL): This type of credit has gained popularity in recent years, offering consumers the option to make purchases and spread the payments over several installments. BNPL is available through various apps and retailers, each with their own terms and conditions. Some charge interest or late fees, while others don't, so make sure to read the fine print.
With open credit, you don't pay upfront. Instead, you use a service and get billed afterward. While it's not your typical credit card or loan, this form of credit can help you manage your daily expenses efficiently, making life more convenient.
- Charge Cards: Charge cards are like credit cards, except you cannot carry a balance—you must pay off all charges in full every month to continue using the card.
- Utility Bills: Utilities like electricity, gas, and water are typically billed after consumption. Customers receive monthly or bimonthly invoices based on their usage. Pay these on time to keep everything running smoothly.
- Other Services: Open credit can extend to cable, internet, and other subscriptions. These providers let you enjoy their services first and pay them later, enhancing your convenience and giving you more control over your finances.
When you use credit wisely and thoughtfully, it can be a versatile key that unlocks countless opportunities. By understanding the nuances of revolving, installment and open credit—and the various options available—you can make sure you're using the right kind of credit at the right time. And when you're looking at applying for new credit, consider things like interest rates, repayment terms, impact on your credit score, fees, and rewards to make the most of your consumer credit and help improve your financial well-being.
