Closed-End Credit: What It Is and How It Works

What Is Closed-End Credit?

Closed-end credit is a loan or type of credit where the funds are dispersed in full when the loan closes and must be paid back by a specific date. Payment for this type of loan also includes interest and finance charges. Closed-end credit may require regular principal and interest payments, or it may require the full payment of principal at maturity. Financial institutions, banks, and credit unions offer closed-end credit agreements.

How Closed-End Credit Works

Closed-end credit is an agreement between a lender and a borrower or business. As noted above, closed-end credit allows individuals and businesses to borrow capital for a specific period of time. With these types of loans, the lender and borrower agree to the:

• Amount borrowed
• Loan amount
• Interest rate
• Monthly payments

These factors depend entirely on the borrower's credit rating. For a borrower, obtaining closed-end credit is an effective way to establish a good credit rating by demonstrating that the borrower is creditworthy. Borrowers who wish to be approved must inform the lender of the purpose of the loan. In some instances, the lender may require a down payment.

With closed-end credit, both the interest rate and monthly payments are fixed. However, the interest rates and terms vary by company and industry. Rates for closed-end credit are generally lower than for other types of credit, such as open-end credit. Interest accrues daily on the outstanding balance. Although most closed-end credit loans offer fixed interest rates, a mortgage loan can offer either a fixed or a variable interest rate.

These types of credit agreements allow borrowers to buy expensive items and then pay for those items in the future. Closed-end credit agreements may be used to finance a house, a car, a boat, furniture, or appliances.

Potential Downsides of Closed-End Credit

Some lenders may charge a prepayment penalty if a loan is paid before the actual due date. The lender may also assess penalty fees if there are no payments by the specified due date. If the borrower defaults on the loan payments, the lender can repossess the property. A default can occur when a borrower is unable to make timely payments, misses payments, or avoids or stops making payments.

For certain loans, such as auto, mortgage, or boat loans, the lender retains the title until the loan is paid in full. After the loan is paid, the lender transfers the title to the owner. A title is a document that proves the owner of a property item, such as a car, a house, or a boat.

Types of Closed-End Credit

As noted above, closed-end credit is one that has a specific end date after which the account is closed. This means that the borrower can no longer access that credit once it is used up and paid back. The following are some of the most common types of closed-end credit:

• Real estate loans, such as mortgages
• Auto loans for new and used vehicles
• Debt consolidation loans
• Other personal loans

Closed-End Credit vs. Open-End Credit

Open-end credit also relies on a borrower's credit history before the lender makes an approval. Credit histories also determine the terms, loan amount, and interest rate among other things. But this type of credit works differently from closed-end credit.

The key differences between closed- and open-end credit lie mainly in the overall terms of the debt and how it is repaid:

• With closed-end credit, debt instruments are acquired for a particular purpose and for a set period of time. At the end of a set period, the individual or business must pay the entirety of the loan, including any interest payments or maintenance fees.
• Open-end credit arrangements are not restricted to a specific use or duration, and there is no set date by which the consumer must repay all of the borrowed sums. These debt instruments set a maximum amount that can be borrowed and require monthly payments based on the size of the outstanding balance.

Open-end credit agreements are also sometimes referred to as revolving credit accounts. Home equity lines of credit (HELOC) and credit cards are examples of open-end credit.

Secured Closed-End Credit vs. Unsecured Closed-End Credit

Closed-end credit arrangements may come in two different forms: secured or unsecured loans.

Closed-end secured loans are loans backed by collateral. This is usually an asset like a home or a car that can be used as payment to the lender if the borrower doesn't pay back the loan. Collateral is often required when the risk of default is higher. In these cases, the lender holds title to the collateral or security until the loan is paid off in full and the account is closed. Unsecured loans, on the other hand, do not require any form of security.

Secured loans offer faster approval. However, loan terms for unsecured loans are generally shorter than secured loans.

The Bottom Line

Credit comes in many different shapes and sizes. But it is commonly divided into two distinct categories: closed- and open-end. While open-end credit lets you borrow for any reason and for an infinite period of time, closed-end credit is different. You must tell the lender what the purpose of the loan is and must agree to pay it off by a certain date. if you've purchased a home or car, you've probably already had a closed-end credit facility.