Understanding how different types of credit work is the key to financial success.
Not all credit is created equal. There are key differences between loans and open credit lines, like credit cards. There’s a defining line between secured and unsecured credit. And there’s even a distinction between good debt and bad debt. Understanding the differences between these various types of credit can help you manage debt strategically and avoid credit problems.
Open vs closed credit (aka revolving vs installment payments)
The first distinction between different types of credit is whether the credit line is a closed-end account or open-end account.
- Closed-end credit is where you borrow a set amount of money as a single-lump sum. Then you pay that debt back over a set period of time using installment payments. This is what you see with loans. The payments are generally fixed from the time you first take on the debt to the time you pay it off. This makes installment debts easier to manage, because you a easily factor the monthly payments into your budget.
- Open-end credit is where a creditor extends a credit line that you can borrow against as needed. You have a set credit limit, but you take out money or make charges as they come up. The debt payments are revolving, meaning they change based on how much you owe. There’s usually a minimum payment requirement that’s a small percentage of your current balance. This is what you get with credit cards and Home Equity Lines of Credit (HELOCs)
Secured vs unsecured
The next key distinction between different types of credit is whether a credit line is secured or unsecured. This refers to whether a debt is backed by collateral. Collateral is something of value that you put up as security for the lender in case you default on a debt repayment.
- Secured credit is backed by collateral. You offer collateral to the lender and if you fail to repay the debt, you can lose the collateral. In many cases, the collateral is the property you purchase with the loan. For example, a home is the collateral on a mortgage and a car is the collateral on an auto loan. With a secured credit card, you put down a cash deposit in exchange for a credit line of equal value; your deposit is the collateral.
- Unsecured credit has no collateral. The creditor extends the credit line in good faith based on your credit score. If you don’t pay an unsecured debt, it goes to collections. Then the collector must sue you in civil court to try a force repayment through things like wage garnishment. But they can’t take any property without a court order.
Good debt vs bad debt
This last distinction relies on what you get from taking on a debt.
- With a good debt, you get something of long-term value in return for taking on the debt. The value that you receive lasts long after the debt has been repaid. Mortgages are good debt, because you get a home and possibly a parcel of land. Both of those things have long-term value that generally increases over time. Student loans are also considered a good debt, because you increase your lifetime earning potential. The ability to make more money and advance you career makes these loans good debt.
- With bad debt, you don’t receive something of long-term value. Credit cards, auto loans and personal loans are all considered bad debt. With credit cards, you generally never get any assets that increase in value over time with your purchase. With an auto loan, the value of the car depreciates quickly, so the resale value is low.
That being said, there can be good reasons to take on bad debt. And you can use bad debts to your advantage. Even creditors like to see these bad debts, like credit cards, on your credit report. It shows you can manage different types of debt.
And it’s worth noting that good debts can be bad for your finances. If you can’t afford to repay student loans or you face foreclosure on a mortgage, that’s bad for you even though it’s a good debt.
Credit reference chart
|Type of credit||Open / Closed||Secured / Unsecured||Collateral Required||Good or Bad|
|Home Equity Loan||Closed||Secured||Home||Usually bad|
|Home Equity Line of Credit (HELOC)||Open||Secured||Home||Usually bad|
|Auto loan||Closed||Secured||Vehicle||Usually bad|
|Student loans||Closed||Unsecured||Good (unless you don’t graduate)|
|Personal loans||Closed||Unsecured||Usually bad|
|Traditional credit cards||Open||Unsecured||Bad|
|Secured credit cards||Open||Secured||Cash deposit||Bad|
|Pawn shop loans||Closed||Secured||Property pawned||Always bad|
|Payday loans||Closed||Unsecured||Always bad|