In the world of loans, mortgages, and financing, the average consumer may feel confused and stressed. Nonetheless, it’s vital to understand how credit and loan types differ, as this will help you decide which path to homeownership is most suitable for you.
If you are short on cash when planning a purchase, an open end credit option may be available to you. But then, there is also the term Closed-End.
Wondering what all of this means? Let’s take a look at the difference between Open End and Closed-End Credit to understand future decision-making better!
What Is Open End Credit?
“openend credit” refers to a loan that a bank or financial institution provides to a borrower. Open end credit is also known as a revolving line of credit and is arranged as a pre-approved amount of credit with no set end date or expiration date.
A borrower may repay the balance before the payments are due, and the loan is usually smaller than a closed-end loan. However, the primary form of mortgage in the US is the closed-end mortgage.
Understanding Open End Credit
Credit cards and open end credit are very similar because the borrower controls how much to borrow. Moreover, unused amounts of the open end credit will not be charged any interest.
In contrast to closed-end loans, such as auto and home loans, this gives borrowers more significant control over when to borrow and a lower interest rate.
There are two types of open end credit available to borrowers:
Having access to funds as soon as a payment is made on a credit card allows more flexibility. As a result, credit cards are the most popular form of open end credit in the consumer market.
However, business is an entirely different story. To approve a line of credit, various metrics and criteria are taken into consideration before determining eligibility. The metrics can include multiple aspects, such as a company’s current revenue, existing collateral, and the value of tangible assets the company owns.
As well as understanding the types of credit, it’s also important to know what terms to look for when taking out a loan!
Choosing the Right Loan Terms
Before signing an open end credit application, ensure that you read the fine print. During your application, here are a few questions you ought to ask:
- Are there any additional charges, such as an annual fee or a monthly fee?
- How much does the interest rate cost?
- Do cash advances have a higher interest rate?
- When paying off the balance, is there a grace period without interest?
When considering open end credit for a specific purpose, such as purchasing a car, compare its APR to what you would pay if you took out a loan for that purpose, in this case, an auto loan.
Benefits And Drawbacks of Open End Credit
An open-ended credit has the advantage of being flexible. Your credit limit can be used all at once, a part of it, or none at all. You may have to pay a monthly or annual fee for keeping an open credit line, but interest is only charged on the amount borrowed. Moreover, there might not be any penalties for paying off the balance at any time. Finally, because the credit can be used for anything you desire, you don’t have to apply for a new loan whenever you need to purchase something.
It is probably the most apparent drawback of open end credit that people tend to use it more often when they have it. A typical American household carries about $16,000 in credit card debt. In addition, after an open end loan is approved, the terms can change at any time, which can be a double-edged sword. For example, your credit limit could increase if your credit rating improves or decrease if the lender views you as a higher risk than when you applied. Finally, interest rates tend to be higher on open end credit (similar to credit cards and personal lines of credit) because there is usually no collateral.
What Is Closed End Credit?
A closed-end loan is one in which the borrower receives funding upfront and is required to repay the debt over a specified period. Interest and maintenance fees accrued during the duration are also included in the amount owed. The closed-end credit loan allows a significant amount of money to be lent out at once.
Closed-End loans can be split up into two types of loans:
A mortgage is usually a secured loan that requires collateral. The borrower agrees to put up something of value as collateral as a guarantee that the loan will be paid back in full if the borrower breaches the contract. Home loans or mortgages have as collateral the house itself.
Cars, balances in saving accounts, or certificates of deposit (CDs) can also serve as collateral. As collateral is added to the transaction, the lender can offer less aggressive rates and fees, although this entails a more significant amount of risk for the borrower. It is less critical to have a good credit score with a secured loan, though collateral is still necessary.
A secured loan could be:
- FHA Loans
- VA Loans
- Fannie Mae and Freddie Mac conventional loans
Unsecured home loans are available from some financial institutions. No collateral is required to obtain the loan, not even your house. Even though unsecured loans seem appealing to homebuyers, qualifying for one can be very challenging, and the borrower may wind up paying more in the long run.
The credit score more heavily influences a debtor’s eligibility and interest rate in the absence of collateral. Loans are typically repaid over the years at rates ranging from 5% to 35% APR.
A lender cannot claim ownership of the home if the borrower defaults on an unsecured loan. Since the borrower does not have any property rights, even if the lender sues, they are less likely to lose the property if they default.
Unsecured loans are underwritten much more rigorously than secured loans, and a borrower’s credit must be nearly perfect to qualify. In addition, the terms and monthly payments for unsecured loans are often shorter.
So, now that we have taken a look at both types of credit let’s sum it all up and point out the differences!
Open End Credit vs. Closed End Credit
Lines of credit are different than closed-end loans, as we explained previously. Lines of credit and closed-end loans differ primarily in how the funds are initially distributed and if they may be repaid, both in the consumer and business sectors. Even though both products have a maximum dollar amount, which is known as the credit limit, loans work differently.
A closed-end loan gives the borrower the full loan amount upfront and requires them to pay it back over time in installments.
Closed-end credit, however, prevents the borrower from withdrawing funds for the second time after repayment, as opposed to open end credit. Hence the term revolving line of credit is often used to refer to open end credits.
When a line of credit is granted, the loan’s total amount can be accessed immediately. Then, depending on current needs, borrowers can borrow as much or as little as they wish. Borrowers can also choose to withdraw funds again as the debt is paid down, making the credit line revolving.
This summarizes the significant differences between open end and closed-end credit, which hopefully helped you understand everything you need to consider before deciding what kind of loan to take out.
But suppose you want to build up your knowledge on the Costs of Open end Credit. In that case, we recommend you check out this journal, which covers consumer behavior, decision making, and the implications of private business practices and government policies for consumers’ wellbeing.
The journal publishes research that considers the consumer’s point of view and the protection of their interests!
So, do your research before taking out a loan to make sure you are making the best decision!
Partner at Vega Capital Management - a private funds management company.
An experienced portfolio manager with 10+ years of proven and reputable track record in investment management and financial analysis. Currently, a partner at one of the fastest-growing private fund management companies in southeast Europe, Kiril has been tending to a loyal international base of client-investors and partners. When he is not crunching numbers and increasing his client’s wealth, he reminisces about his Michelin-star restaurant cheffing years and fondness of the culinary arts.