Part 1: Types of Credit
Not many years ago a prospective borrower’s credit alternatives were limited, in terms of both the kinds of loans that were available and the types of lenders which were actively making those loans. Today there are many different types of consumer credit that are available from a wide variety of sources. Some loan agreements specify equal monthly or annual payments, while others require a large single payment of both principal and interest. Some loans require nothing more than a borrower’s promise to pay (in other words, a note); others necessitate that the borrower pledge certain assets as collateral to guarantee repayment of the loan.
Consumer credit can be divided into two broad categories: installment credit and noninstallment credit. Installment credit, also called closed-end credit, includes loans that require the borrower to repay the principal mount in equal periodic payments, usually monthly. A loan to purchase an automobile is one example of installment credit. It’s also a popular method of financing other high-end appliances and electronics, such as refrigerators, washing machines or computers. The lender will ordinarily retain the title to the property (if one exists) until the loan is paid completely. These fixed-payment loans typically provide the borrower with very little repayment flexibility.
Noninstallment credit, which essentially includes all forms of consumer credit other than fixed-payment loans, is comprised of single-payment loans and loans that permit the borrower to make irregular payments and to borrow additional funds without submitting a new credit application. This latter type of loan is also known as revolving- or open-end credit.
Single-payment loans (or term loans) require the repayment on a specified date of the entire amount that was borrowed. Term loans may demand periodic interest payments, but more often than not require the accumulated interest to be paid at the same time that the loan’s principal is due.
Open-end credit allows the borrower to draw out additional funds as they’re needed, so long as the total outstanding loan balance doesn’t exceed a predetermined limit, known as the credit limit or line of credit. Charge accounts (such as Sears and J.C. Penny) and credit card accounts (like MasterCard and Visa) are the most common examples of open-end credit. These types of accounts permit a continuous source of credit. The borrower reduces the debt by making payments and can also add to it by borrowing, or charging, addition amounts without having to reapply for credit. Generally, open-end credit accounts allow irregular or partial payments to be made subject to a predetermined periodic minimum amount established by the lender. This minimum may be a stipulated dollar amount or a percentage of the outstanding balance.
A personal line of credit allows the borrower to draw out funds as needed, generally by the use of special checks supplied by the lender. The checks can be used to pay for goods and services or deposited into the borrower’s checking account. The line of credit permits the borrower to obtain and repay funds at his or her convenience, subject to the line’s maximum amount. Interest charges are based on the amount of the outstanding balance and the length of time the funds remain unpaid.
Home equity loans use the equity (the market value of a property less any outstanding loans against it) of a borrower’s home as collateral and can be structured either as a line of credit (HELOC) or as an installment loan (HEL). They are convenient forms of borrowing money at a very competitive interest rate.
Travel and entertainment (T&E) accounts, offered by American Express, Diners Club and other financial services companies, provide credit for a specified period (generally thirty days), at which time the entire outstanding balance must be paid in full. They do not permit partial-payment of their bills, and they’re generally accepted by fewer merchants when compared with Visa or MasterCard. T&L companies also tend to be more selective regarding the applicants who are approved to receive their credit cards.
Thirty-day accounts permit customers to defer payment for purchases made by up to thirty days without incurring interest charges; the full amount, however, must be paid by the due date. Service credit, which is offered by utility companies, doctors, and other suppliers of services, allow customers to make payment fifteen to thirty days following the date that the service is provided, with no interest charges being accrued.
Part 2 of this series will discuss the various types of lenders which provide consumer credit.