When you plan to make a purchase but find you don’t have the cash on hand, open-end credit may be an option. Open-end credit refers to any type of loan where you can make repeated withdrawals and repayments. Examples include credit cards, home equity loans, personal lines of credit and overdraft protection on checking accounts.
Open Versus Closed-End Loans
Open-end loans are set for a fixed amount, like the credit limit on a credit card. Each month, you are required to pay a minimum amount of what you owe, but you may pay off the entire balance at any time.
As a contrast to open-end credit, closed-end loans are taken out for a specific reason, like a car loan or mortgage. For example, if you want to buy a car, the loan can only be used for that car. You can’t use the money to go on vacation instead. A closed-end loan is for a fixed period of time, with regular payments of a set amount. Provided you make the payments as required, the loan terms generally do not change. When you make your final payment, the loan is closed. If you need to borrow money again, you must apply for another loan.
Benefits of Open-End Credit
The main benefit of open-end credit is its flexibility. You can use all of your credit limit, a part of it or none of it, as needed. Although you may be charged a monthly or annual fee for keeping the credit open, you’re only charged interest on the outstanding amount you borrow. Additionally, you may be able to pay off the balance at any time without penalties. Because you can use the credit for anything you want, you don’t have to apply for a new loan every time you want to make a purchase.
Drawbacks of Open-End Credit
Perhaps the biggest drawback of open-end credit is that when people have access to it, they tend to use it. In fact, the average household in the U.S. carries about $16,000 of credit card debt.5 Additionally, the flexibility of an open-end loan can be a double-edged sword because the terms of the loan may change at any time. Your credit limit, for example, could be increased if your credit rating goes up, but could also be decreased if the lender believes you are a higher risk today than when you first applied. Because there is usually no collateral on open-end credit (similar to most credit cards and personal lines of credit) interest rates tend to be higher.
Loan Terms to Look For
Be sure to read the fine print before signing an open-end credit application. When you apply, ask the following questions:
- Is there an annual or monthly fee in addition to interest charges?
- What is the interest rate?
- Is there a higher interest rate for cash advances?
- Is there a grace period of no interest if you pay off the balance?
If you need the loan for a specific purpose, such as buying a car, compare the annual percentage rate, or APR, of the open-end credit to what you’d pay if you took out a loan for that purpose, in this case an auto loan.