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Credit wars: revolving vs. installment

Believe it or not, "debt" doesn't always have to be a dirty word.

When used well, debt can be a helpful financial tool. It can help you buy a house, pay for schooling or buy the perfect family car. However, used recklessly, debt can also be a black hole that sucks away your money, your credit score and your peace of mind.

Fortunately, consumers have numerous options when it comes to borrowing money. Matching the right credit tool to your particular situation can help you pay less in the short term and stay in control of your finances over the longer term.

There are basically two kinds of credit: installment loans and revolving credit -- and it's extremely important to understand the differences.

Installment loans
We usually use installment loans to buy things such as homes or cars -- bigger-ticket purchases over an established repayment period. You take out installment loans for specified amounts, such as $2,500 to buy a used car for your son.

You know in advance how much your monthly payment will be and how long it will take to pay off the loan (also known as the "term of the loan"). As a result, installment loans are easy to work into your budget. They can also carry extremely competitive rates, in the 5- to 7-percent range.

When you begin paying back an installment loan, most of what you're paying is interest. Over time, however, you begin paying an increasing portion of loan principal, too. This steady, increasing reduction in the principal amount is called amortization. If you need to borrow additional funds during the loan repayment period, however, you must take out a new loan or use some other form of credit.

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There are two types of installment loans:

  • Secured loans are linked to some sort of collateral, such as a car, boat or home that the bank could confiscate and sell if you don't pay back your loan. They usually carry lower interest rates than unsecured loans.
  • Unsecured loans are riskier to a bank and therefore carry a higher interest rate. This loan hinges only on your good reputation: your credit score, payment history and job status, for instance.

Revolving credit
Revolving forms of credit are more open-ended than installment loans. Lines of credit and credit cards are both examples of revolving credit. In essence, revolving credit means you are given a set amount you may borrow (also known as your credit limit). As you pay back the money your credit limit "revolves" back up to what it was originally, say $5,000 or $10,000. You can dip into your pool of credit many times and for many purchases -- as long as you continue to pay the money back.

You pay a steep price for this flexibility, however. Revolving credit rates vary widely, depending on your credit and payment history, but can be range from 10 percent to more than 20 percent. And, card issuers reserve the right to increase your interest rate at any time if you don't pay your bill on time.

Revolving credit is popular today because it's easy and quick to get approved for it. Even folks with dinged credit histories are usually able to get credit cards. In addition, revolving forms of credit have much smaller required payments than installment loans. That's because your minimum monthly payment is based on only a small percentage (perhaps 2 percent) of your outstanding balance that particular month.

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-- Posted: Sept. 20, 2004
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2004 Debt Guide
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