There are two types of credit available to businesses – revolving and installment – and both are valuable for different reasons and in different circumstances. To help you determine the best type of credit for your particular situation, let’s explore the differences between the two.
Revolving credit involves an open-ended credit account that can be used at any time and for any purpose, up to a pre-set borrowing limit. While there’s a minimum payment required each month, payment amounts can vary and funds repaid are immediately available to be borrowed again.
Business credit cards and lines of credit are two of the most common forms of revolving credit.
“Revolving credit offers tremendous flexibility,” Rob Spicer, business advisor at BlueShore Financial, explains, “and if a company is strong financially and there is security backing the account, higher borrowing limits and lower interest rates may be available.”
Installment credit, on the other hand, involves funds borrowed for a set period of time (the term) that are repaid through scheduled, periodic payments – most often monthly. Typically based on an amortization schedule, installment loans involve the gradual reduction of the principal amount owed until full repayment is made and the credit agreement ends.
Spicer notes, “With installment credit, the funds repaid are not available to be borrowed again unless a new credit application is submitted and approved.”
The purpose of an installment loan is usually specified with the application. Because the risk to the lender may be less (the loan can be secured, at least in part, by the asset being acquired), interest rates may be lower.
Common forms of installment credit include commercial mortgages and vehicle or equipment loans.
Secured versus unsecured credit
Secured credit is backed or secured by tangible assets, while unsecured credit is not.
“Both revolving and installment credit can be secured or unsecured depending on the financial strength of the company, the policies of the lender and the reason for the loan,” says Spicer. “Unsecured credit is much riskier for the lender and hence typically carries a higher interest rate.”
When a business should use these forms of credit
Because of its flexibility and the fact that it can be put in place (even if not used) and available immediately, businesses can effectively use revolving credit to provide working capital to help with business operations and cash-flow management. Running out of cash is detrimental to any business, and revolving credit can provide a short-term solution.
Credit cards can be used for smaller monthly expenses, while a revolving line of credit can help cover larger operating costs or unexpected situations while waiting for accounts receivable and other sales to be paid.
Installment credit is most often used for the acquisition of big-ticket items such as real estate, vehicles and other capital assets. Scheduled monthly payments make budgeting easier because you know how much your monthly payment will be and how long you have to make payments. With an installment loan the acquisition of more expensive items or better equipment can be made more affordable, leaving cash and revolving credit available for day-to-day operating requirements.
It’s important to remember that an installment loan usually involves an application and approval process once a decision is made to acquire an asset.
Get expert advice
“Depending on your situation and the financial strength of your company, revolving and installment credit can both be used to help manage and grow your business,” says Spicer. “It’s important to consult with your team of advisors, especially your financial business advisor, to help you decide on the best solution for your circumstances.”