A pre-approved loan between a lender and a borrower
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Open credit is a pre-approved loan between a lender and a borrower. It allows the borrower to make repeated withdrawals up to a certain limit and then make subsequent repayments before the payments become due.
Borrowers prefer open-end credit because it gives them greater control over the amount they can borrow and the repayment period. Interest is only charged on the credit that the borrower has used, and the borrower does not incur costs on the unused credit.
An open credit can take the form of a loan or credit card. Credit cards are the most common forms of open credit, and they provide flexible access to funds whenever needed. A credit card allows the holder to access funds in the form of cash advances, whose limits are predetermined by the issuer based on several factors, such as the borrower’s credit rating and credit score.
The credit card holder can continually use the card to make purchases online and in-store, and if the cardholder makes a payment before the credit limit is exhausted, funds are made available immediately. In the consumer market, home equity loans are an example of an open-end credit, which allows homeowners to access funds based on the level of equity in the homes.
An open credit is a financial arrangement between a lender and a borrower that allows the latter to access credit repeatedly up to a specific maximum limit.
Once the borrower starts making repayments to the account, the money becomes available for withdrawal again since it is a revolving fund.
An open credit does not come with restrictions on the use and duration of the loan.
How Open Credit Works
When a lender and a borrower enter into an agreement for an open-end line of credit, the lender allows the borrower to access and utilize the funds. In exchange, the borrower agrees to make timely payments to the account for any active debts.
The agreement sets out the maximum amount that the borrower can borrow at any particular time, and interest is charged on the outstanding balance of the account. The borrower is required to make interest and principal payments based on the outstanding balance of the account.
The maximum amount of credit available to the customer is known as the revolving credit line. The limit is revisable, and the borrower can request an increase in the maximum credit limit if the limit is not enough for their needs. The lender may agree to increase the limit if the borrower has made timely payments to the account, and he/she has a clean credit history.
Conversely, the lender can reduce the borrower’s credit limit if the borrower begins to default on repayments or their credit score declines. When the borrower makes payment to the open-credit account, the funds become available for borrowing again. The borrower can continually utilize the credit as long they do not exceed the revolving credit line.
Advantages of Open Credit
1. Readily available
One of the reasons why an open-end credit is preferred is that it makes money available to borrowers if and when it is needed. Generally, it is uneconomical and expensive for a borrower to borrow money repeatedly every two or three months and repay it fully.
An open-end credit solves such a problem by making credit available for use if and when it is needed without requiring the borrower to make repayments by a specific date. Instead, it allows them to repeatedly utilize the money and make timely payments before the limit is attained.
2. Lower interest rates
In addition, borrowers benefit from lower interest rates on loans, since the interest is only charged on the outstanding amount of loan rather than the unutilized portion of the loan. It makes open-end credit an ideal option for a self-employed individual with an unpredictable income.
Disadvantages of Open Credit
1. Higher interest rate and maintenance fee
Open credit accounts are unsecured credit, and no collateral is attached to them. Therefore, an open-end credit tends to attract a higher interest rate than secured loans from banks and credit unions. Also, the lender charges a monthly or annual maintenance fee for keeping the credit account open, adding to the overall cost of running the open-end account.
2. Unexpected changes in credit terms
Another limitation of the open credit is that the terms of the credit can change at any time. The lender can decide to increase the maximum credit limit if the borrower’s credit rating improves. Also, the credit limit can also be reduced at any time if the lender believes that there is an increase in credit risk or a decrease in the credit score.
Closed-end Credit vs. Open-end Credit
Closed-end and open-end credit differ depending on how funds are disbursed and how payments are made to the account. In a closed-end credit, the amount borrowed is provided to the borrower upfront. The credit is obtained for a particular purpose, and the borrower is required to pay the entire loan, including the interest and maintenance fees, at the end of the set period.
As monthly installments are made, the balance owed to the lender decreases. Unlike in an open-end credit, where the borrower can withdraw funds again after payment, the funds provided in a closed-end credit cannot be withdrawn a second time.
Open-end credit is not restricted to a particular purpose, and the borrower can access as much or as little money as they need as long as they make timely payments to the account.
CFI offers the Commercial Banking & Credit Analyst (CBCA)® certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below:
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