There are so many different definitions and terms when it comes to finances that it can get overwhelming at times. Starting out with basic terms is crucial to becoming knowledgeable and successful with money. Let’s delve down into some basics of debt terminology to get you on your way to becoming an expert.
What is the difference between Revolving and Installment debt? It’s a fairly basic answer but comes with a lot of side turns. Simply stated, revolving debt is debt that has no end date and installment debt is for a specified amount of time.
Revolving Debt
With revolving debt, a lender gives a borrower a set credit limit amount which they can borrow against indefinitely and repeatedly (the no end date part). Typically borrowers are required to make some sort of minimum payment, which is commonly a percentage of the outstanding balance or a minimum amount.
Common examples of revolving debt are credit cards and home equity lines of credit (HELOC loans). All types of lines of credit are generally classified as revolving det. With these kinds of debt, you’re able to draw against your limit as many times and as frequently as you want if you don’t go over your credit limit. And when you make payments, you replenish your credit availability. Let’s look at an example. If your credit limit is $1,000, you can charge up to that amount on the account. If you charge $300 in items in one month, you have a $700 limit remaining. Upon your payment date, the amount paid restores (gets added back to) your available credit. This repeats itself monthly as long as you have the credit card or line of credit.
Utilization Rate
This is a perfect time to jump in and touch base about another term important to debt (borrowing) and even more important for your credit score. The utilization rate is the amount(s) you owe divided by your credit limit(s). In our previous example with charges of $300 in a month and a credit limit of $1,000, you have a utilization rate of 30%. So, if you take all your credit limits from ALL your debt (revolving/installment) and divide it by your credit limits, you get the magic number. This includes ALL debt. Examples not only include credit card debt and lines of credit but also mortgages, student loans, outstanding IRS debts, and car loans.
Having a credit utilization rate higher than 30% can result in a hit to your credit score. 30% (coincidentally) of your credit score is based on your utilization rate. Your goal is to not have a rate higher than that magic 30%. How can new borrowers do this? It can take time, but here are a few tips.
Let’s start with credit cards. When you’re young and getting your first credit card, you will have a very low credit limit. You could have a limit as low as $100, but more likely in the $500 range. If you have a $500 credit limit, that means that you shouldn’t charge more than $150 in any given month. If you don’t pay off the entire balance on the due date (don’t recommend), then you even have less the following month to stay below the 30% threshold. It seems like a cycle that some can’t get out of. If over your first year, you don’t have issues with keeping your utilization rate lower than 30%, I would recommend having your credit limit raised. It’s a simple phone call to the creditor to ask for a limit raise. If you have paid your bill timely, the answer will likely be yes. **However, it should be noted that if you are overspending and want to raise the limit to accommodate that spending, you’re going down a dangerous path that’s hard to return from.
Student loan debt (installment debt discussed later) is a harder bird to deal with. Especially since many student loans don’t even begin repayment until 6 months upon graduation or you stopping your education. Due to that, it’s not surprising to see utilization rates at 100% or even higher. What!!?? How could the utilization rate be higher than 100% for some student loans?? With unsubsidized loans, the interest begins accruing upon inception even though the payments may not begin until many years later. So, when the payments begin, the borrower owes more than they borrowed, giving the loans a utilization rate higher than 100%.
Pros and Cons of Revolving Debt
Revolving debt is quite flexible and you can borrow whenever you need or want it. Also there’s the reality that as long as you don’t exceed your limit, you don’t have to go through a new application process every time there is a need for more money.
As for cons, there are many. After the first quarter of 2023, America’s total credit card debt was $986 billion, which is the highest since the New York Fed began tracking in 1999. With an average APR (annual percentage rate) of 20.24% (new offers) and an average of 20.68% for all credit card accounts, you can see how it would be easy to get into a large amount of revolving debt. Per CNBC, “on average, Americans carry around $5,733 in credit card debt, according to TransUnion’s latest report.” Gen X tends to carry the highest average due to “being sandwiched between caring for elderly parents and raising their own kids – maybe even putting them through college.”
Revolving Interest Rate Example
You have a credit card with a limit of $1,000, you charge $300 within one month, but only pay off $50 when the bill comes due, leaving a remaining balance of $250. Your credit card comes with an interest rate of 20.99% APR (annual percentage rate). Let’s look at how much you will owe when your next bill comes around without charging anything else on the card.
The APR is ANNUAL so you want to determine how much interest you pay every day with compound interest (covered in more detail elsewhere). 20.99% / 365 (days) = .0575% per day. The day after your payment is due and you don’t pay your balance in full, your interest begins. **No interest ever begins accruing if you pay your account in full every month.
Remaining balance of $250 + .0575% = $250.14. That doesn’t seem so bad so far. But on the 2nd day, you’re charged interest on the $250 PLUS the interest that’s accumulated. That means you’re paying interest on interest. ☹
Day 2: $250.14 + .0575% = $250.29
Day 3: $250.43
Day 4: $250.58
Day 5: $250.72
You can see how your balance continues to rise daily with unpaid balances. This calculation is rudimentary to give you an idea of the calculation, but there are apps and software that can give you more specific calculations. Now, think about additional items being added to the balance with new purchases and you’re now paying interest on that too. If you had just paid it all off in the previous month, no interest would’ve accrued. Each month, you get to purchase items interest free if you don’t carry a balance from the previous month. However, if you do, you get charged on ALL of it.
Another downside to revolving debt is that if you’re late on a payment, not only do you get a late fee, but you chance an increase in your interest rate. Make sure that you read the fine print and are aware of any interest rate clauses. But wait, it gets worse, late payments appear on your credit report and will reduce your score potentially causing future problems in borrowing. On time payments are 35% of your credit score and the most important factor in calculating your score. *If unforeseen circumstances occur, don’t hesitate to call your lender and explain that it was an error and ask them to waive the late fee. If you don’t make a habit of this, they will waive it. I’ve had to do this over the years and have never been denied the waiving. Also note that a late payment will trigger interest being charged so ask those to be waived as well if you’re paying it in full.
Installment Debt
A main difference between revolving and installment debt is that installment contains a specific end date and the payment amounts are typically (we’ll revisit this) the same every month for the duration of the loan term.
Common examples of installment debt are car loans, student loans, personal loans and mortgage loans. Most likely you’ll also receive an amortization schedule that shows how much each payment gets attributed to principal versus interest. At the beginning of the loan term, the majority is paid toward interest and then reduces over time since it’s based on the principal balance that is reduced as payments are made. In an installment loan, you “receive” the entire amount of the loan all at once unlike revolving debt. For car loans, you receive the car. Student loans, you receive the money to pay the school. For personal loans, you get the money. For mortgage loans, you get the home. And then over time, you pay off those things that you receive.
For almost all loans, you know how much your payment is for the entire term and it’s typically the same amount every month. If you ever want to borrow additional money, you must apply for a new loan, which is different than revolving debt. Installment debt is harder to qualify for as compared to revolving debt. It seems like anyone over 18 can get a credit card nowadays. However, with installment debt, you’ll be critically evaluated to determine if you’re a good risk. If you have a good credit score, you’ll have a lower interest rate as compared to someone who has a lower score.
It’s a risk vs reward scenario for lenders. If it’s a higher risk for them, they will charge you a higher interest rate. Lenders know that people will default on loans and they will lose money. To offset that, they offer a higher interest rate to give them immediate return since much of your payment is in interest at the beginning of the loan. If you’re a safe bet, lenders feel more comfortable offering you a lower rate to attract your reliable business. You are a stable borrower that is almost guaranteed to pay off the debt in full.
For installment debts, you can have a fixed rate or variable rate. A fixed rate is exactly like it sounds. You maintain the same interest rate throughout the entirety of your loan. If it’s a car loan for 4%, it stays at 4% for the entire 5 years. There are some clauses that can be found in installment loans that might change your interest rate or trigger other things to happen. An acceleration clause calls the entire loan due immediately and can be caused by missing too many payments. An interest rate clause increases the APR (annual percentage rate) upon specific circumstances such as last payments. **Make sure you are aware if your loans include these types of clauses.
Pros and Cons of Installment Debt
The consistency of the installment debt payment is helpful in budgeting each month. Installment debt also tends to carry a lower interest rate as compared to revolving debt. These are both benefits. Due to the lower rates, people have been known to take out a personal loan or HELOC (home equity line of credit) to pay off credit cards. This seems like a good decision in theory, but this can be dangerous as a HELOC is tied to your home (secured loan covered below) and if you default, you could lose your home. Another downside is that each time you need additional funds, you are required to go through the application process again, which can be time consuming and expensive depending on the type of loan.
Secured vs Unsecured Debt
What secured loans or debt are is right in the name. Secured. That means that the debt is tied (secured) to an item or said to have collateral backing. Examples include car loans, mortgage loans, HELOCs (home equity lines of credit) and some other personal loans (furniture, jewelry, etc.). If there is collateral in a loan, it means the payment is secured by that item. In a default situation, the lender can repossess or take back the item. Because the loan is tied to a collateral item, interest rates are lower as compared to unsecured debt. Going back to the risk vs reward, the lender could take possession of an item to offset any potential losses, unlike in an unsecured scenario.
In opposition, unsecured debt does not have collateral and upon default, there is no item that can be seized. Because of that risk to lenders, the interest rate will be higher. Again, to the risk vs reward. Examples of unsecured debt are credit cards, student loans, and medical debt.
You may be wondering which kind of debt is better, revolving or installment. There are downsides to all kinds of debt, but both revolving and installment can be useful when you need to borrow money. The decision depends on your needs and what kind of purchases are being made.
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