What is Closed-End Credit?
Closed-end credit is a facility where the borrower can draw the available amount once and must repay by a specific date including interest.
It comes with a specified term, interest rate, installment method, and repayment terms. The borrower can only withdraw the available funds once and will repay over the loan term in monthly or quarterly installments.
Once the borrower repays the loan amount on time or earlier, it cannot be reused. It means a closed-end credit is a one-time financing facility and the lender will close it once it has been repaid.
Many closed-end credit facilities impose penalties on early and loan prepayments because they earn interest over the loan term. In any case, once you repay the borrowed amount in a closed-end credit, you wouldn’t be able to reuse that money even if the loan term is remaining.
How Does Closed-End Credit Work?
Closed-end credit facilities are agreements between borrowers and lenders with specified terms and conditions.
A lender will typically require collateral against these facilities. The credit amount will also depend on the credit score, monthly income, and financial strength of the borrower.
Once the lender approves the credit facility, the borrower can withdraw that amount. The repayment terms usually include a fixed or variable APR, minimum monthly payments, late fee penalties, prepayment penalties, and maturity date.
Closed-end credit facilities are usually taken out for specific purposes, for example, auto loans and home mortgage loans. If that is the case, the borrower cannot use these funds for any other purpose.
These credit facilities may require interest-only payments for a specific period. However, the borrower must repay the principal amount plus the interest by the end of the loan term.
Types of Closed-End Credit
Most installment loans and fixed-interest loans are types of closed-end credit facilities. Then, these credit facilities can be categorized based on their features and terms as well.
Secured and Unsecured Loans
Secured loans are backed by collateral. Common examples of these loans include home equity loans, secured business loans, finance leases, etc.
Unsecured loans do not require any pledge from the borrower. Personal loans and auto loans are common examples of unsecured loans.
Fixed and Variable Interest Rate Loans
A fixed interest rate loan is a type of loan where the interest rate remains the same over the life of the loan. It will not change even if the market interest rate changes over time.
Variable interest rate loans come with floating or varying interest rates. These types of loans charge a base (fixed + Linked) interest rate plus a floating interest rate.
Personal Loans
Personal loans are also called installment loans. These credit facilities come with fixed or variable interest rates and can be used for any type of personal use.
Business Loans
Most small business commercial loans are closed-end credits as well. These loans can be secured or unsecured depending on the borrower’s creditworthiness.
Closed-End Lines of Credit
A line of credit is typically an open-end credit. However, if it comes with a specified maturity date and repayment term, it will be a Closed-End credit facility.
Pros and Cons of Closed-End Credit
Closed-end credit comes with its pros and cons.
Pros of a closed-end credit facility include:
- Predefined loan terms including loan maturity and minimum monthly payment requirements.
- These loans often come with lower APRs as compared to open-ended credit.
- Lenders feel secure with closed-end credit facilities as the credit profile of the borrower can change over time.
- Borrowers can plan accordingly for interest and the principal loan amount repayment.
Cons of closed-end credit include:
- Borrowers cannot reuse the facility.
- Borrowers often face prepayment penalties for early closures.
- These loans often require collateral.
What is Open-End Credit?
Open-end credit is a type of credit that can be reused after the initial approval. The borrower can repay the full amount borrowed and reuse it multiple times as and when needed.
In simple words, once a lender approved an open-end credit, the borrower does not need to reapply for the same facility again.
The lender will set an upper cap on the borrowed amount. The borrower would be able to withdraw funds up to the maximum limit at any time.
Also, the borrower will pay interest on the utilized amount only. If the borrower wishes not to withdraw funds from an open-end credit, the lender will not charge interest.
How Does Open-End Credit Work?
The lender appraises the credit application of the borrower and sets a maximum open-end credit limit once. This appraisal depends on different factors including credit score, monthly income, credit history, and so on.
Once the lender approves an open-end credit facility, the borrower can withdraw any amount up to the maximum limit at once or partially. Moreover, the lender will charge interest on the withdrawn amount only and not the approved credit amount.
As the borrower repays the withdrawn amount, the available credit amount tops up again. So, the borrower will again be able to withdraw that available amount without reapplying every time.
This is the reason; open-end credit facilities are often called revolving credit facilities. A home line of equity and credit cards are common examples of open-end credit facilities.
Types of Open-End Credit
In theory, any credit facility without a predetermined maturity date is an open-end credit. These facilities include credit cards and loans.
Credit Cards
Banks and credit unions issue credit cards without expiration dates. However, the maximum credit limit varies depending on several factors including the creditworthiness of the borrower.
Open-End Loans
A revolving loan like a home line of credit is a common example of open-end loan. The borrower can use the borrowed amount multiple times as long as the credit facility remains open.
Open-End Vs Closed-End Line of Credit
A life of credit or a revolving loan is usually an open-end credit facility as it does not come with a maturity date. The borrower can reuse the line of credit as long as it is available with the mutual consent of both parties.
A closed-end line of credit is a special type of financing facility that combines the benefits of revolving credit and also comes with a predetermined maturity date.
The borrower can reuse the line of credit multiple times. However, it must be repaid and settled in full at the maturity date. A bank overdraft is a common example of a closed-end line of credit.
Pros and Cons of Open-End Credit
Open-end credit facilities are flexible financing options for borrowers and come with several benefits.
Pros of open-end credit include:
- Borrowers need to apply once and can reuse the approved loan limit multiple times.
- Typically, borrowers pay interest on the withdrawn amounts only.
- Approved credit amounts can be used for any purpose without restrictions from the lenders.
- These loans do not require collateral usually.
- Open-end credit facilities are flexible financing options for borrowers and approved limits can be increased with improved credit scores.
Cons of open-end credit include:
- Maximum credit amounts are significantly lower as compared to closed-end credits.
- Lenders require higher credit scores and creditworthiness as there is no collateral.
- Late payments can incur penalties and may affect the upper borrowing limit.
- Lenders typically charge higher interest rates on these credit facilities.
Open-End Credit Vs Closed-End Line of Credit – What’s the Difference?
Both types of credit facilities come with discrete pros and cons. Let’s summarize some key differences between both types of credit facilities.
Approval Process
Open-end credit facilities come with easier application processes. However, approval is often difficult as it depends on the credit profile of the applicant.
Closed-end lines of credit and other loans require significant documentation and formalities. Borrowers may use cosigners and collateral to boost their approval chances.
Credit Amount
Open-end credit facilities are revolving financing options. These loans come with lower credit approval amounts though.
Closed-end credit facilities offer higher loan amounts as often they are secured with collateral.
Collateral
Most open-end facilities do not require collateral from borrowers. Credit cards and line of credit facilities come without collateral requirements.
Closed-end loans may come with collateral requirements. These loans can be secured or unsecured depending on different factors.
Interest Rates
Open-end or revolving lines of credit facilities typically charge higher interest rates. These rates are also often variable.
Closed-end credit facilities charge lower and fixed-interest rates commonly.
Repayment
Open-end line of credit requires minimum monthly payments. Borrowers can reuse the available limits multiple times.
Closed-end credit loans also require minimum monthly payments. At maturity, borrowers must repay the principal amount. The facility cannot be reused.
Settlement of the Facility
Open-end facilities often do not come with an expiry date. However, lenders may terminate the facility if the borrower’s credit profile changes or due to any other factor.
Closed-end facilities are settled by repaying the principal amount in full before the maturity date.
