Depending on the need, an individual or business may take out a form of credit that is either open- or closed-ended. The difference between these two types of credit is mainly in the terms of the debt and the debt repayment.
Closed-End Credit
Closed-end credit includes debt instruments that are acquired for a particular purpose and for a set amount of time. At the end of a set period, the entirety of the loan must be repaid, including any interest payments or maintenance fees.
Common types of closed-end credit instruments include mortgages and car loans. Both are loans taken out for a specific period, during which the consumer is required to make regular payments. In loans like this, when an asset is being financed, the issuing institution usually retains some ownership rights over it, the as a means of guaranteeing repayment. For example, if a customer fails to repay an auto loan, the bank may seize the vehicle as compensation for the default.
Open-End Credit
Open-end credit is not restricted to a specific use or duration. Credit card accounts, home equity lines of credit (HELOCs) and debit cards are all common examples of open-end credit (though some, like the HELOC, have finite payback periods). The issuing bank allows the consumer to utilize borrowed funds in exchange for the promise to repay any debt in a timely manner.
Unlike closed-end credit, there is no set date when the consumer must repay all of the borrowed sum. Instead, these debt instruments set a maximum amount that can be borrowed – though this – and require monthly payments based on the size of the outstanding balance. These payments include interest, of course.
The maximum amount that can be borrowed, known as the revolving credit limit, is often revisable. Account-holders can request an increase, or the lender might automatically raise it as a reward to a loyal, responsible customer. The lender might also reduce the limit, if the customer’s credit score has dropped drastically or a pattern of delinquent payment behavior begins. Some card companies, such as American Express and Visa Signature, allow most cardholders to go above their limit in case of an emergency, or if the overdraft is relatively small.
Line of Credit
A line of credit is a type of open-end credit. Under a line of credit agreement, the consumer takes out a loan that allows him to pay for expenses using special checks or, increasingly, a plastic card. The issuing bank agrees to pay on any checks written on or charges against the account, up to a certain sum.
This type of credit is often used by businesses, which can use company assets or other collateral to back the loan. Such secured lines of credit often have lower interest rates than unsecured credit, such as credit cards, which have no such backing.
For more, see What Are Some Good Alternatives to Taking out a Line of Credit?