Let’s talk credit! Credit is money you borrow and must repay. Depending on the type of credit account it is, you can use it for different purposes, like buying a boat, funding a wedding or buying an investment property.
There are two main types of credit available to borrowers – closed-end credit and open-end credit. Of course, it’s important to know which type you’re applying for. We’ll touch on both here but mainly focus on closed-end credit.
Closed-End Credit vs. Open-End Credit
Let’s take a quick look at the differences between closed-end credit and open-end credit:
- Closed-end credit: This is an installment loan borrowers usually take out for a specific purpose. Lenders extend a specific amount of money that must be repaid (including interest) over a set time frame. Mortgages, car loans or student loans are examples of closed-end credit.
- Open-end credit: This is revolving credit (aka line of credit). Lenders extend a line of credit with a fixed credit limit to borrowers. Borrowers can repeatedly tap into the line of credit during the withdrawal period. The funds can be used for pretty much any purchase or investment as long as you don’t exceed your credit limit. You only pay interest on what you withdraw or use for purchases. Credit cards, home equity lines of credit (HELOCs) or personal lines of credit are examples of open-end credit.
How Closed-End Credit Works
Closed-end credit is a one-time installment loan you usually take out for a specific purpose. You make monthly payments that include the loan’s principal balance and interest during the repayment period. If you need more money after the loan is paid off, you’ll need to apply for a new loan.
Your monthly payment will stay the same if you have a fixed interest rate (which is the most common scenario). Your monthly payments could increase or decrease if you have a variable interest rate. Your rate will be determined by your loan type, your lender and your credit scores. Closed-end credit interest rates are usually lower than open-end credit rates.
The repayment period depends on the loan type and which lender you choose. A mortgage loan will have a much longer repayment period than a car loan, and a car loan could have a longer repayment period than a personal loan. The lender will set the loan’s repayment period, which is usually expressed in months or years.
If you apply for closed-end credit for a specific purpose, the money you receive must be used for that purpose. For example, you use a mortgage to purchase a home or an auto loan to purchase a car. If you get a personal loan, however, lenders are typically more flexible about how you use the funds.
Secured vs. Unsecured credit
Whether it’s closed-end or open-end credit, there are times when you may need to secure the credit to be approved by a lender or creditor. When you secure credit, you can typically borrow more money or get better loan terms. It may also help you qualify for a loan or line of credit if you have bad credit.
- Secured credit: To receive secured credit, you must offer the lender collateral (like your house or personal assets) they can repossess in case you default on the loan. Secured loans can be easier to qualify for than unsecured loans and typically have lower interest rates and higher credit line amounts. Before you’re approved, the lender must determine how much the collateral is worth, which may increase your wait for the funds.
- Unsecured credit: Because unsecured credit doesn’t require collateral, you can usually get the money faster because the lender won’t spend any time determining the value of any collateral. But you usually can’t borrow as much money as you could with a secured loan because there is no collateral to secure the debt. These loans can be harder to get than secured loans and typically have higher interest rates.
Will Closed-End Credit Affect Your Credit Scores?
Closed-end credit affects your credit like any credit account would – how you manage your debt can impact your credit scores. If your lender reports your account to the credit bureaus, they will send monthly updates of your payment activity.
Your payment history makes up a large portion of your credit score. Late payments on your closed-end credit accounts can decrease your credit scores; on-time payments can boost your scores.
Once your loan is paid off, the account is closed. The closed account will show up on your credit reports for up to 7 years if there were any derogatory remarks (like a delinquency) or up to 10 years if it was closed in good standing.
Your credit utilization ratio, which is how much money you owe compared to how much you can borrow, is also a large part of your credit score. But it’s calculated based on your open-end credit accounts (credit cards or lines of credit), not your closed-end credit accounts (mortgages, car loans, student loans, etc.).
Bonus tip: Credit mix makes up a small percentage of your credit scores, so having different types of credit accounts can slightly impact your scores. If you can responsibly manage the debt, a mix of open-end credit accounts and closed-end credit accounts can help boost your scores a bit.
How Do You Get Closed-End Credit?
You can apply for closed-end credit from a bank, a credit union (if you’re a member) or an online lender. Depending on the type of loan you’re looking for, there may be lenders that specialize in those loans, like mortgages or student loans.
Lenders will look at your credit history to help determine your creditworthiness (an indication of how much lenders can rely on you to repay a loan). Depending on the loan and the lender, borrowers may need to meet different requirements to qualify. Usually, the main requirements you’ll need to meet are:
- Minimum credit score
- Proof of income and residence
- Debt-to-income (DTI) ratio
In some cases, you may need to make a down payment on your loan, and many fees could come with it. A lender may also ask you to provide additional information like bank statements, assets, proof of insurance or titles.
Borrow Once, Then Repay
If you’re unsure what type of credit you’re applying for, ask yourself if you can only borrow money once or if you can repeatedly borrow from a line of credit. With closed-end credit, you borrow money once and repay the loan. With open-end credit, you continuously borrow from your credit account and repay as you go.
As with any type of credit, make sure you can afford to repay what you borrow before you apply.
TransUnion®. “How Long Do Closed Accounts Stay on My Credit Report?” Retrieved May 2022 from https://www.transunion.com/blog/credit-advice/how-long-do-closed-accounts-stay-on-credit-report