Credit cards versus installment loans: benefits and drawbacks of each
Most people may need to borrow money at some point. In fact, the average revolving debt per adult in the United States is more than $4,000.1 Even if you're generally financially comfortable, you may appreciate the option of financing to pay for your education, purchase a home or to pay for necessary or elective healthcare services. Fortunately, there is no shortage of credit products available.
Unsecured credit cards and installment loans are two popular borrowing options. Both have a variety of benefits and some drawbacks. Below are some possible differences between unsecured credit cards and loans.
Unsecured versus secured loan products
When a loan product is described as "unsecured", it means that the borrower is not required to pledge collateral (such as a home or a car) in order to "secure" the loan. If a borrower does not pay a "secured" loan per the terms of the loan agreement, then the lender can under certain circumstances require the borrower to surrender the collateral in order to satisfy the balances owed. All else being equal, unsecured loan products typically feature a higher interest rate than secured loan products (such as auto loans and leases, home mortgage loans, home equity loans and lines of credit, et cetera).
How are credit cards and installment loans different?
If you've ever wondered "What is an installment loan?" you're in good company. Many people may not fully understand how installment loans work, or how they are different from credit cards. An installment loan is a type of loan that is paid back in equal payments (installments) over a predetermined length of time.2 There are benefits and drawbacks to installment loans and credit cards.
Benefits of credit cards
Credit cards offer some attractive features, including:
- Safer than carrying cash.
- A convenient form of payment.
- At least 21 days to pay for new purchases without paying interest, if the entire account balance is paid in full by the due date each month.3
- A credit limit that renews as you pay off the existing balance.
- No pre-payment penalties.
- Some cards offer the opportunity to earn rewards on purchases.
A credit card offers a revolving credit limit that renews as you pay off the existing balance. The total credit limit of the card, less any existing account balances and pending charges, is the "available credit limit" that can be used to make additional purchases.
Paying with "plastic" may also be safer and more convenient than carrying cash. If your cash is stolen, you may not get it back. However, if your credit card is stolen or lost, you can report it to the issuing bank to limit your responsibility for unauthorized charges to no more than $50 per incident.4In fact, many cards advertise "zero liability" for unauthorized charges.
There is no penalty for paying your balance in full at the end of the month, or making more than the required minimum payment at any time.
Some credit cards allow you to earn rewards for making purchases, for example earning cash back, travel discounts or airline miles.
Finally, credit cards are an option for building your credit score. One way to build your credit score is to make regular purchases and pay your statement balance in full by the due date each month.
Drawbacks of credit cards
There are a number of benefits to using a credit card, but opening an account may come with a few drawbacks as well, including:
- The potential to negatively impact credit score.
- The possibility of interest charges.
- Making only the required minimum monthly payments may not facilitate quick repayment.
- The possibility of fees: annual fee, balance transfer fee, foreign transaction fee, cash advance fee, et cetera.
Carrying a high credit card balance may have a negative impact on your credit score. If you make late payments or miss payments, or if your credit card balance exceeds half of your credit limit (for example, a $3,000 balance on a card with a $5,000 limit) your credit score may be negatively impacted.
Credit card fees can vary significantly, depending on the card you choose. Common types of fees include foreign transaction fees, cash advance fees and annual fees. And, if you carry a balance on your card you may pay interest.
One final drawback of credit cards is that if you consistently pay only the required minimum monthly payment, it may take you a long time to pay off the balance.
Benefits of installment loans
Benefits of an installment loan may include:
- Fixed repayment term.
- Fixed interest rates (typically).
- Fixed monthly payments.
An installment loan comes with a fixed length of repayment, for example, 24, 48 and 60 months. Unlike a revolving line of credit, an installment loan is issued for a predetermined amount of money. If you wanted to borrow again, you'd have to apply for a new loan.
Installment loans typically carry a fixed interest rate, which means your interest rate will not change as you repay your loan. This type of loan requires fixed monthly payments that, if satisfied, pay the loan off over a fixed schedule.
Drawbacks of installment loans
If you're considering an installment loan, you should know that there can be drawbacks associated with taking out an installment loan:
- For a predetermined amount of money.
- The credit line does not renew after payoff.
- The potential to negatively impact credit score .
- Interest is charged from the date of the loan agreement (there is no interest-free period).
- The possibility of fees: loan origination fees, prepayment penalties.
Some installment loans may involve fees, including origination and prepayment fees. An origination fee is assessed at the time the loan agreement is signed. A prepayment penalty may also be assessed if a loan is paid off before a particular date.
Which is right for you?
As with any loan, it's important to do your homework in advance. Make sure you understand the obligations associated with the credit card or installment loan before signing any paperwork.
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1"Consumer Credit — G.19" June 7, 2018, https://www.federalreserve.gov/releases/g19/current/, accessed June 26, 2018. (source for current revolving credit balances) "American Community Survey Demographic And Housing Estimates" 2016, https://factfinder.census.gov/faces/affhelp/jsf/pages/metadata.xhtml?lang=en&type=table&id=table.en.ACS_16_5YR_DP05#main_content, accessed June 26, 2018. (source for US adult population)
2"What Is Installment Credit?"" September 29, 2016 Experian.com, https://www.experian.com/blogs/ask-experian/what-is-installment-credit/, accessed June 22, 2018
3"Credit Card Accountability and Responsibility and Disclosure Act of 2009", https://www.gpo.gov/fdsys/pkg/STATUTE-123/pdf/STATUTE-123-Pg1734.pdf, accessed June 26, 2018.
4"Credit Card Accountability and Responsibility and Disclosure Act of 2009", https://www.gpo.gov/fdsys/pkg/STATUTE-123/pdf/STATUTE-123-Pg1734.pdf, accessed June 22, 2018.