Types Of Credit
What Are The Different Types Of Credit?
Lenders (banks, credit card agencies and car financiers among others) make credit available to individuals in several different forms. There are two main types of credit: Revolving & Installment.
Different Types Of Credit
Installment Loans:
An installment loan (also known as a close ended loan) is when a borrower borrows a specific amount from a creditor, they then pay back this loan plus interest in small chunks or installments over a pre determined period of time. Each repayment includes the interest on the loan and a predetermined portion of the principal. These loans are usually also secured against an asset, the most common type being a traditional mortgage.
Example: Cindy borrows $300,000 from a bank to buy her first house, she has a fixed interest rate of 5% per annum. She has a fixed term of 30 years and is required to make a repayment once per month of $1610.46. This is an example of an installment loan.
An installment loan is most typically used when you are borrowing a set amount for a specific purpose and are unlikely to need additional credit in the near future – as if you do another application for credit will need to be made.
Revolving Loans:
A revolving loan (also known as a line of credit) is a more flexible type of credit than an installment loan. The lender will give the borrower a maximum amount they can borrow up to, then the borrower can use this money as they need it and only pay interest on the amount they’ve used so far. The most common form of a revolving loan is a credit card.
Example: Taylor has a credit card with a $400 credit limit. Taylor uses his credit card to pay for a $200 pair of jeans, she then pays off $150 leaving $50 owing. Later in the month he uses his credit card to pay for his electricity bill which set him back $350. He now owes the bank $400 which is his maximum – he cannot make any more purchases using this credit card until he has paid some of it off.
More Specific Types Of Credit
These two broad categories of credit can be broken down into smaller more specific types of credit, there are limitless specific types of credit – outlined below are some of the more popular options.
Overdraft
This is when your bank allows you to take more money out than you currently have in your account. This is usually an extremely temporary measure and their are high interest rates and stiff fees/penalisation for using an overdraft facility. Most banks also only allow a small amount to be over drawn (less than $100), this type of credit is most often used when a person hasn’t budgeted correctly and believe they have more money in their account than they actually do.
Credit Card/Store Card
A credit or store card is the most common form of a revolving loan. You can use these cards to pay for almost anything these days and at the end of each month you are required to pay off a monthly minimum or the full balance or anywhere in between. If the monthly minimum is not bad then you’re usually charged a late fee.
Unsecured Loan
An unsecured loan is almost always an installment loan, it’s useful when needing to raise a large sum of money. It’s important to make sure that you can afford the monthly repayments before applying for an unsecured loan as these are generally approved or denied based on your salary.
Secured Loan
The most common type of secured loan is a mortgage. When you have a secured loan you put an asset (in this case your house) as security for the loan, if you fail to pay the monthly repayments then the security (in this case your house) will be repossessed and sold to recoup the loaned amount. These are almost always installment loans.
Store Finance / Hire Purchase
When you buy an item with store finance your are usually required to pay a monthly repayment, this is another form of an instalment loan. Because you are able to use the item while you pay it off this is also known as a hire purchase. These are almost always extremely bad value with high interest rates, lots of businesses try to make these types of loans more appealing to customers by offering an interest free period.
These are extremely profitable loans for businesses because they make money off the sale of the item plus they make money off the loan itself.
Pawnbroking
Pawnbroking has made a resurgence recently with shows such as pawn stars. Pawnbroking is a form of a secured loan except that while the money is borrowed the pawnbroker keeps physical possession of the asset you’re using for security. In most cases the pawnbrokers are hoping that you don’t pay the money back as they undervalue your asset and then sell it on to other customers.