Depending on certain factors, an individual or a business may decide to take out an open or a closed-ended loan. The primary differences between these two types of loans are how long the loan will run and the repayment conditions. However, it often goes deeper than that. Below, we highlight the distinctions between open and closed-ended loans, making it easier for prospective borrowers to make the right choice.
What are Open-Ended Loans?
An open-ended loan describes a revolving line of credit with little-to-no restrictions on repayment conditions, loan duration, or how you use the loan. The important thing is getting approved for the amount you want. Once approved, you can take out that amount and pay it back on an ongoing basis, as long as you don't exceed your credit limit.
The lender does not specify a date when you have to pay back a revolving line of credit. Instead, you are required to make monthly repayments depending on how much unpaid balance you have left. Once you've repaid entirely, you can restart the process by taking out a loan for the same amount you were initially approved for. Examples include credit cards and a home equity line of credit (HELOC).
Secured Open-Ended Loans
Open-ended loans may be secured or unsecured. A secured loan is tied to a piece of collateral you offer to the lender. Credit card loans, for example, may be secured using an account you maintain at the lending institution, while a HELOC is secured by your home and its accrued equity. Because of the collateral, secured open-ended loans may come with higher credit limits and lower APRs than the unsecured ones. However, if you default on a secured loan, you stand to forfeit the collateral.
Unsecured Open-Ended Loans
Unsecured loans are granted without collateral. In this case, credit is approved primarily based on the borrower's creditworthiness. An unsecured credit card is an excellent example in this category. The better your credit history, the higher the limit, and the lower the interest rate you are offered.
With open-ended loans, if you default on repayment regularly, your credit limit will be reduced. Same if your credit score drops drastically. Conversely, if you pay back your balance on time, the lender may increase your limit as a reward for your loyalty and financial responsibility. Likewise, you can request that your limit be increased, provided your repayment history is sparkling and your credit rating is stable.
What are Closed-Ended Loans?
A closed-ended loan comes with a fixed loan amount that has to be paid back (along with interest fees) within a specified timeframe. The borrower is expected to make regular repayments throughout the life of the loan. Closed-ended loans are typically taken out to serve a specific purpose, e.g., a mortgage to finance a home purchase or an auto loan to purchase a vehicle. Personal loans are an exception to this. While they have similar features with other closed-ended loans, they can be taken out without restriction vis-à-vis usage.
Financial institutions that provide closed-ended loans generally hold ownership rights over the asset the loan was used to finance. This serves to ensure repayment. For example, if you get a car loan, the company has part-ownership of the car. If you don't pay back within the stipulated duration, the lender may repossess the car as compensation.
Open or Closed-Ended Loans?
So which loan type should you opt for? This depends mainly on what you plan to use the loan for. In certain conditions, an open-ended loan is an ideal option. Sometimes, the reverse is the case. Here are some tips to help you along:
- Open-ended loans are suitable for small and continuous purchases like gas and groceries. They are also great for instances when you have unexpected expenses and you don't have (or don't want to empty your) savings. Closed-ended loans are ideal for more significant purchases. The consistent monthly payments are easier to budget for, and you can plot your repayment schedule from the start.
- Open-ended loans do not typically charge prepayment penalties, while some closed-ended loans do. So, if you take out the former and you come into some money, you can decide to pay off your loan earlier than stipulated without being penalized. You can't do the same with the latter. NOTE: These days, most closed-ended loans don't charge prepayment penalties either. Before signing on to a loan, make inquiries to ensure there is no penalty for early repayment.
- Closed-ended loans, in general, charge lower interest rates than revolving lines of credit. This is probably because they represent a safer option for the issuing institution. They know how long it will take the borrower to repay and how much will be paid back each month. Secured open-ended loans, however, may come with low interest rates. This is because there is collateral involved, and the lender can seize it if the borrower defaults.
- Most open-ended loans come with variable interest rates. During the life of the loan, your interest payments increase or decrease depending on Fed funds rates. This makes long-term, open-ended loans harder to budget for. With closed-ended loans, however, you may choose between a fixed or a variable interest rate. Since you have the luxury of choice, you may pick the option that suits you the best.
- One of the most significant advantages of credit cards is that, if properly managed, the consumer may end up paying little-to-no interest. Card issuers often stipulate a day every month for consumers to pay off their card balance. If you pay off your balance on/before that day, you won't be charged interest. As a result, you may maintain the line of credit for a long time, taking out money when you need it and paying it back as at when due. If you keep this up for long, your credit rating improves, and the lender may increase your credit limit.
An open or closed-ended loan? It depends on where you are financially, and as mentioned before, what you need the loan for. If you need to buy a car, it is unlikely that you will get a card that offers you enough credit limit to do so. You may have no choice but to opt for a closed-ended auto loan. However, if you own a home with enough equity, you may put it up as collateral and get a revolving line of credit.
For the average person, open-ended loans are great for small or unexpected expenses, while closed-ended loans may be used to finance more significant purchases.