Consumer credit is vital to the financial ecosystem, powering economies worldwide and enabling consumers to make purchases that might otherwise be out of their reach. However, not all consumer credit works the same way. There are various types of consumer credit, each with its own unique characteristics, advantages, and disadvantages. In this, we will look at a few examples of common consumer credit types and how they work.
Revolving credit, which includes credit cards and home equity lines of credit (HELOCs), allows consumers to borrow up to a certain limit, repay the money (with interest) in variable amounts at their own pace (within certain limits), and borrow again as long as the account remains open. This flexibility makes revolving credit popular for daily expenses, emergencies, and varying costs like home renovations, where the total cost may not be known upfront.
The revolving credit is different from the type of credits where you have to decide on an amount in advance and borrow that amount as a lump sum. For people who are discplined with their money, revolving credit can be great, since you can elect to use exactly the amount of credit needed and not a cent more. For those who struggle to stay disciplined, it can be too tempting to have a larger amount of credit pre-approved and readily available.
Installment credit involves loans with a set number of repayments, known as installments, over a specified period. Car loans, student loans, and personal loans are often offered in the form of installment loans.
Mortgage loans, too, fall under this category, being a long-term loan where borrowers repay the credit over years or decades. Mortage loans are typically used for substantial, one-time expenses, e.g. purchasing the real estate that will serve as collateral for the mortage loan.
For smaller installment loans, the repayment period can be fairly short, e.g. 12 months.
Many creditors will create a repayment plan for your installment loan where you repay exactly the same amount each month, since this makes it easier for borrowers to budget. During the first few repayments, the part of the repayment that goes towards the interest will be comparatively big, since you have a big principal to pay interest on. As the principal gets smaller with each repayment, the amount of interest charged will also go down. Therefore, more and more of each repayment will go towards paying down the principal.
Open credit, such as utility services or cellular contracts, involves debts that must be paid in full every month. While there’s typically no interest, but late payment penalties can be steep. Many consumers do not even thing about this as a type of credit, since they never borrowed any money. It is a credit, however, since you have been provided with goods or services without paying in advance for them.
Payday loans are short-term, high-interest loans meant to be repaid on the borrower’s next payday. These loans are often used by those with low credit scores who need quick cash for emergencies. Payday loans with harsch repayment terms and conditions can quickly lead to a cycle of debt due to the high interest rates and fees.
If you have taken out a payday loan in an emergency situation and is struggling to repay it, do not put your head in the sand. Contact the lender and see if you can be granted a longer repayment plan. It is better to have a somewhat longer plan that you can handle (even if it means a bit more in interest payments) than a short plan where you will incurr huge late fees and damage your credit score.
Another option is to contact other potential lenders, now when the emergency is over and you have a bit more time to shop around, and see if you can obtain a loan with better terms and conditions, and a more sensible repayment plan, which you can use to pay back the payday loan immediately.
Also known as P2P lending, this method lets individuals borrow and lend money without a financial institution as an intermediary. Online platforms connect borrowers and lenders directly. The interest rates vary, but can be lower than traditional loans for borrowers with good credit. Make sure you understand how the platform works and what the fee structure looks like before you use any P2P credit service.
Unsecured credit doesn’t require collateral, making it riskier for lenders and therefore often carrying higher interest rates. Credit cards and student loans are common examples of unsecured credit.
Secured credit, on the other hand, requires an asset to be used as collateral. Examples include the mortgage loan secured by the house and the car loan secured by the vehicle. Since the lender has the right to take the asset if the borrower fails to repay, interest rates for secured loans are typically lower and these loans can also be easier to qualify for.
Each type of consumer credit serves a different purpose and comes with its own set of terms and conditions. When seeking credit, it’s crucial to understand these variations and choose the option that best suits your financial situation and goals. Also remember that the differences can be huge even within the same category.
Always read the fine print before taking on any credit, consider the interest rates and fees (including potential fees such as late fees). Remember, the most informed decisions come from understanding the full picture.
Consumer credit can be a useful financial tool when used responsibly. By understanding the different types of consumer credit, borrowers can make strategic decisions to support their financial health.
This article was last updated on: June 6, 2024