by Christy Bieber | Aug. 16, 2019
Both revolving debt and installment loans allow you to borrow, but they work differently. Here are some of the key differences.
Before you borrow money, it’s important to understand exactly how your debt will work, and one of the first things you need to know is whether the debt is revolving debt or an installment loan.
Installment loans are loans for a fixed amount that are paid back on a set schedule. With revolving debt, on the other hand, you’re allowed to borrow up to a certain amount, but can borrow as little or as much as you want until you hit your limit. As you pay it down, you can borrow more.
Let’s take a closer look at both installment loans and revolving debt to better understand the key differences between them.
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Installment loans can have fixed interest rates, which means you know up front exactly how much you’ll pay in interest per month, and in total. They can also have variable rates. If you opt for a variable-rate installment loan, your interest rate is tied to a financial index (such as the prime rate), and can fluctuate. While your payment amount can change with a variable rate loan, your repayment timeline is still fixed -- your payment amount simply goes up or down as your interest rate changes, ensuring you can pay back the loan on time.
Most installment loans are paid monthly. You’ll know up front exactly when your debt will be paid off, and if it’s a fixed-rate loan, you will also know the loan’s total cost. These loans are very predictable -- there are no surprises.
Revolving debt works differently. Common examples of revolving debt include home equity lines of credit and credit cards. With revolving debt, you’re given a maximum borrowing limit, but can choose to use only a little bit of your line of credit, if you want. If you’re given a $10,000 home equity line of credit, for example, you might initially only borrow $1,000 from it. As you paid that $1,000 back, the credit would become available to you again.
Some revolving debt is open-ended, which means your credit line can stay open indefinitely, and you can borrow and pay back your debt forever. This is the case with credit cards. In some cases, you may have your line of credit available only for a limited time, such as 10 years for a home equity line of credit.
With revolving debt, you don’t know up front what the total cost of borrowing will be, or when you’ll pay back your debt. That’s because you could borrow and pay back your loan and borrow and pay back your loan over and over while your line of credit is open, with your payment and interest costs re-determined each time based on the amount borrowed. In many cases, revolving debt also charges a variable interest rate, which means interest costs can change over time.
When you take out an installment loan, you get the entire amount you’re borrowing in one lump sum when you close on the loan. If you took out a $10,000 personal loan, you’d have $10,000 deposited into your bank account, or would get a $10,000 check. If you decide you need to borrow more money, you’d be out of luck -- even if you paid off almost your entire $10,000 balance. You would need to apply for a new loan to borrow more.
With revolving debt, you get to choose when you borrow funds. You could borrow right after opening a credit card, wait six months, or wait years to borrow, depending on what you want (although if you don’t use your card for too long it could be closed due to inactivity). As long as you haven’t used your full line of credit, you also have the option to borrow again and again, especially as you pay down what you’ve already borrowed.
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Installment loans tend to be best when you want to borrow to cover a fixed cost, such as that of a car or another big purchase. If you know you’ll need to borrow but it’s hard to predict when you’ll need the money or how much you’ll need, then revolving debt may make more sense.
Installment loans come with a predictable repayment schedule. You agree up front with your lender on how often you’ll pay, and how much you will pay. If you have a fixed-rate loan, your payment never changes. So if you borrowed money on a five-year term and your monthly payments started out at $150 per month, five years from now, they’d still be $150 per month.
Revolving debt payments depend on how much you’ve borrowed. If you haven’t drawn from your line of credit, you won’t pay anything. Usually, when you’ve borrowed, you pay your revolving debt on a monthly basis. But, you may pay only a small portion of what is due. When you have a credit card, for example, your minimum payment may be either 2% of your balance or $10, whichever is lower.
If you make minimum payments only on revolving debt, it can take a long time to pay back what you owe, and you’ll pay a ton of interest during the time the debt is outstanding.
Now you know the key differences between revolving debt and installment loans, which include:
You’ll need to decide which type of financing is right for your particular situation so that you can get a loan or line of credit that makes sense for you.
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