Specific challenges require specific solutions. Different credit accounts have different features and, when used responsibly, provide flexibility that can help you achieve your financial goals. It’s important to know how different types of accounts work so you can use them effectively and have the freedom to pursue what matters.
Two of the main types of credit accounts are installment and revolving. An installment account is what you might imagine a typical loan to be. A mortgage, car loan or personal loan is an example of an installment loan. These usually have fixed payments and a designated end date. A revolving credit account, like a credit card, can be used continuously from month to month with no predetermined payback schedule.
When you take on an installment loan, you’re usually agreeing to pay back a specific amount of money over a specific period of time. You’ll make consistent monthly payments based on the principal balance and loan interest rate. The principal balance is how much you borrowed. The amount you owe in interest will vary based on the type of loan and payback schedule. For example, many mortgages have 15 or 30 year terms. Car loans often have terms that range from two to seven years.
The payment you make to the lender each month on an installment loan includes both interest and principal. And, unless the terms of the loan change, you’ll generally pay the same amount each month. At the beginning of your payment schedule, more of your monthly payment will go toward interest. Over time, the amount of interest you pay decreases and more of your monthly payment goes toward the principal balance. You can see how this works with our mortgage loan calculator tool.
Revolving lines of credit
A revolving account like a credit card differs from an installment loan because it gives you access to an always available credit line, which is how much you can charge to that account at any given time. How much you owe and whether you owe interest each month depends on how quickly you pay off what you’ve charged. You will be given a due date each month which requires a minimum payment, though this minimum payment may be less than the full balance. Typically, if you carry a balance from one month to the next, you will owe interest. You can use revolving credit as needed, which gives you flexibility. But that flexibility can come at a price if you don’t pay your balance in full each month—interest rates on revolving accounts are often higher than installment loans. Personal and home equity lines of credit are additional examples of revolving accounts.
Understanding the key differences between your credit accounts can help you manage your cash flow, avoid unnecessary interest and fees and build good habits to maintain a healthy credit history.