For anyone working toward achieving better financial health, it’s essential to understand the three main types of credit — installment credit, revolving credit, and open credit — and the ways they impact your credit score.
Credit indicates a lender’s confidence that a loan will be repaid. Someone with good credit reflects that they have built up a high degree of trust from lenders and the lenders have confidence that they will make payments on time.
Having credit allows you to make purchases that you might not be able to afford via a lump sum payment. Credit gives you, the borrower, an ability to pay off purchases over time through a series of (usually monthly) payments. However, the condition attached to making immediate purchases and gradually paying them off is that the lender will charge you interest — which may accumulate until the loan has been repaid.
A person with good credit has the benefit of lower interest rates compared to those with bad credit. Someone with bad credit might not even be able to obtain a loan.
Credit history is maintained and updated monthly by the three main credit bureaus: Equifax, Experian, and TransUnion. The information in your credit report is used to calculate a credit score.
Two companies, FICO® and VantageScore, use similar but distinct methods to determine a credit score, which prospective lenders then use to judge your creditworthiness. This information is used to determine whether or not you should be granted a loan and to assess the amount of interest to charge you.
Generally speaking, there are three different types of credit: revolving credit, open credit, and installment credit. Each form of credit is defined based on how debt is borrowed and repaid, which varies with each type. But before we explain further, there are a few definitions to keep in mind.
Secured credit refers to a loan that is guaranteed by a form of collateral. An example is auto loans and mortgages. When you use these types of loans, the purchased automobile or house serves as collateral. If you don’t make payments, a creditor can repossess your car or foreclose on your home. These types of loans are usually installment loans, which means that the lender disburses the loan via a lump sum, and the borrower pays them back in predetermined payment amounts.
Unsecured credit refers to loans that aren’t guaranteed by collateral. These often take the form of revolving credit. Common examples include student loans, personal loans, and credit cards. However, some experts argue that credit cards should be placed in a separate category, distinct from secure and unsecured loans. They claim that not all credit cards are the same, and cards differ in offerings and structure.
Most credit cards offer the option of paying off the total amount owed in full or paying a minimum payment and carrying a month-to-month balance. However, some cards, such as charge cards, require you to pay off the owed balance each month.
In addition, some credit cards are secured by collateral. For secured credit cards, the collateral is money you pay as a deposit to open the line of credit. It can also be a linked banking account; it is only tapped if you don’t make payments. These cards can be an effective way to build credit for people who have no credit history or are starting over due to low credit scores.
Oliver Browne, a credit card analyst at Credit Card Insider, explains the logic behind revolving credit:
“Revolving accounts allow you to borrow over and over, up to an approved amount. The amount is set by the lender, but it’s up to you how much you want to borrow at a given time. The prime example of revolving credit is a credit card. There are usually minimums that you must pay, but you can usually decide to pay more. For example, if you have a minimum payment of $200 for your credit card, you can decide to pay a larger amount, like $500 towards the balance instead.”
Forms of revolving credit accounts include:
With a revolving credit account, the minimum payment is typically a percentage of your total balance. So, if you had to pay at least 3% of your balance each month, that means if the balance owed is $100, you’d have a $3 minimum payment, but if the balance is $1,500, you’d have to pay $45.
For these credit accounts, you can pay off the entire balance or repay in increments of minimum payment or higher. As you pay off your balance, the available credit rises back up towards your limit.
But unless you’re paying the entire balance every month, you’ll be making extra payments than what you originally owed. Your credit won’t rise by the same amount as what you’re paying. That’s because interest accrues at a steady rate. So you might make a $30 payment but only get $20 in credit back because $10 went towards paying off the accrued interest charges.
As you can imagine, making the minimum payment, especially on a large account balance, could make you feel like you’re spinning your wheels but going nowhere. If you’re only making the minimum payment, you won’t make much progress toward paying off your debt, especially if you continue to make more purchases through that line of credit without first paying off the balance owed.
The best way to avoid overusing revolving credit is to pay off your debt in full each month. If you have other obligations and can’t pay off the account, be sure to keep your balance below your credit limit and avoid taking on too much credit card debt.
Not only will doing this keep you from spending a lot of money on interest, but it will also help maintain a low credit utilization ratio on your credit report, which is a significant factor in determining your credit score.
"Installment credit is when you borrow from a lender for a fixed amount with fixed payments. This credit type includes student loans, car loans, and personal loans,” explains Browne.
With installment credit, you don’t have the option of making additional purchases with the line of credit. You’re given a one-time lump sum loan that you repay, with interest, over time.
The advantage of this form of credit is that you know exactly how long your payment period will be. And when you complete the set payments, it’s done. You can pay off your debt early in most cases, but some installment creditors do not allow this.
Many installment credit plans involve using the loan for a specified purchase, such as a house, car, or smartphone. As a result, they tend to be secured loans. If you default, the creditor can repossess the specific item you used the loan to purchase.
Still, not all installment loans are secured. Personal loans —which can be used for anything from consolidating debt to home repairs— are usually unsecured loans.
Open credits typically don’t have a hard-set credit limit. Payments are due in full each month, and the amount you have to pay may vary based on your usage. Sometimes they’re tied to how much you use a specific service, whether provided by a private company or local government entity.
Utility bills for electricity, gas, sewer and water usage are often open credit accounts in newer credit score models. Many people don’t realize it, but utility payments may affect your credit score. As this is a newer practice, utility payments aren’t usually considered for loans, such as mortgages. Utility payments usually only impact your credit if your payments are delinquent.
Charge cards, which often have no preset credit limit, are another form of open credit. With these cards, you’re expected to pay off the full card balance each month or face the consequence of high fees or a closed account.
“In most cases, yes. Installments and revolving credit are going to affect your credit score. If you miss payments, it could drop your score,” Browne says.
One of the main things all credit types have in common is that they affect your credit score.
“If you don’t pay installment or revolving, you’ll likely see a decrease in your score. If your payment behavior is bad for either type of credit, you’ll likely see a decrease,” Browne explains.
“When you apply for a credit card [or loan], make sure that your lender reports positive activity to the credit bureaus. You need to ask, ‘If I pay my bills on time every month, are you going to report positive activity and behavior to the credit bureaus?’ If you’re not checking, you’re wasting an opportunity to build credit,” advises Browne.
Your credit score is calculated based on a variety of different factors, some of which have more weight than others.
You don’t have to pay to check your credit score. You can sign up for free to monitor your VantageScore credit score and see where you stand. The VantageScore model is slightly different from FICO in the factors it calculates for its score. The score ranks the following from your credit history:
Both credit scoring models use slightly different categories to measure how good your credit is:
For FICO, anything over 800 is exceptional; 740-799 is very good; 670-739 is good; 580-699 is fair, and scores under 580 are poor.
For VantageScore, the list is as follows: 781-850 excellent; 661-780 good; 601-660 fair; 500-600 poor; and 300-499 very poor.
If you’re applying for a mortgage, the minimum FICO score needed to qualify is 620. You have a little more leeway with an FHA mortgage: You can get an FHA loan with a score of 500-579, but you’ll need to pay a 10% down payment to do so. If you have a score of 580 or better, you can qualify for an FHA loan with a down payment of 3.5%, though the specific credit score requirements vary from lender to lender.
Generally, the lower your credit score, the more you should expect to pay in interest, no matter the loan type you’re seeking. For large loan amounts, higher interest can quickly add up.
For example, an installment loan in the form of a fixed-rate mortgage of $300,000 can cost you nearly $95,000 more in interest over 30 years with a score of 620-639 than it would if you had a score of 760-850. Similarly, a score of 720 or more could get you a 13.5% interest rate, or lower, on a credit card, whereas a score under 620 would vault you over 20%.
Ideally, you should have all three different types of credit. In terms of your FICO score, having a mix of revolving credit, installment credit, and open credit could help, especially if you are trying to build your credit.
“The way this works is it’s best to have a variety of different types of accounts because they will more positively impact your score, rather than just having one type of account. Variety of accounts makes up about 10% of your FICO credit score. If you’re showing that you can maintain and manage diverse accounts, it will look even better,” Browne says.
Lenders want to see that you can responsibly manage different types of credit. And having multiple types of credit indicates that you might be a lower risk to them if they loan you funds.
Your credit mix is one factor in your credit score calculation, but it isn’t the only one. As mentioned above, it accounts for 10% of your FICO score, so compared to your credit utilization rate, it’s only a third as important.
It has equal weight to the new credit category. So, it wouldn’t be wise to go out and start applying for numerous different kinds of credit within a short period because each credit application counts as a “hard inquiry.” Having too many of those in a short period of time can drop your credit score.
It’s better to apply for different kinds of credit only as you need them—Plan to space your loan applications out. And after you get approved, be sure to consistently make on-time payments to ensure you’re satisfying the No. 1 factor in determining your FICO score.
Having good credit is a critical aspect of your overall financial health. Credit can help you afford big purchases you ordinarily can’t afford in a single payment. It can also provide you with a financial cushion in emergency situations. And it might even help you get a job or an apartment because some employers and landlords review your credit score as part of their background check.
If you’re interested in building or improving your credit score, Browne offers a simple first step:
“If you’re looking to build your credit, read up on basic credit terms and make sure that you know how credit works. Stay updated with the major credit bureaus and review your credit on a frequent basis as you try to build your score. It’s also a good idea to get copies of your report because errors can occur sometimes, so always keep an eye on them.”
Making timely payments is the most important factor in determining your FICO score. It’s best to pay off your credit each month to keep the interest from accumulating.
Missing payments will also cause your credit score to drop, in addition to the added late fee payments and penalties from the creditor. However, if you have larger loan amounts or are unable to make a full payment, it’s crucial to stay on top of your monthly charge. Work with your financial institution to set automated monthly minimum payments.
If you’re less than a month late with a payment, it won’t be reported on your credit. If you miss a payment by more than 30 days, you’ll receive a negative mark on your report, and your credit score will suffer. So if you have a late payment, it’s important to resolve the issue as soon as possible because each additional 30-day delay will continue to damage your credit.
If you notice a mistake on your credit report, make a point to dispute it, so it doesn't drag down your score. You can dispute inaccuracies —identity errors, balance errors, transposed numbers, and duplicate entries— by disputing the error with the credit bureau for which it appeared on the report. Generally, disputes can be made by phone or mail.
Errors on credit reports are far more common than you might expect. In a 2021 Consumer Reports investigation, nearly 6,000 volunteers found at least one error in more than one-third (34%) of their reports. It is also cheap to be on the lookout for fraud. Every year, you are entitled to a free copy of your credit report from each of the major credit bureaus. So, make it an annual tradition to take a look at your credit report for discrepancies that might be hurting your credit score.
Don’t submit multiple credit applications within a short period of time. Each time a company checks your credit to review a credit application, it counts as a hard inquiry or “hard pull.” Hard pulls can stay on your credit report for up to two years and might shave a few points off your credit score.
However, not all credit checks impact your credit score. Inquiries conducted by potential employers, auto insurers calculating premiums, or credit card companies for preapproval offers are considered “soft” inquiries which don’t affect your credit score.
A secured credit card may be a good solution for someone with no credit history or who wants to rebuild poor credit. The line of credit that comes with a secured credit card gives you an opportunity to rebuild your credit, assuming you make consistent on-time payments.
To get a secured credit card, most financial institutions require you to provide a cash security deposit that is often equal or greater to the opened line of credit. As long as payments are made, your security deposit won’t be taken.
But, you have to be mindful. Since the card is likely to have a low credit limit, you can quickly charge too much and increase your credit utilization rate, which is the second-most-important factor for calculated credit score. Having a high credit utilization rate will cause your credit score to drop.
So, if you opt for a secured credit card, you should closely monitor your spending and avoid going over 30% of the available limit.
A credit builder loan is an option for people with little to no credit history who want to potentially build up their score. You can apply for a credit builder loan without having to go through a hard pull on your credit history. If you are approved, the borrowed amount is kept in a bank, and you’re not allowed to access it until you’ve completed payments.
Usually, the process gives you an option on the amount of money to pay off each month and a loan term that fits your budget. Although you don’t get the money immediately, the history of your regular on-time payments is reported to the credit bureaus, which helps you build your credit via your payment history.
Developing good credit is an essential component of any personal finance strategy aimed at improving financial health. It’s important to focus on all three types of credit accounts to mix up and help you build your credit.
Having a diverse mix of credit is one of the key factors in building a good credit score. There are multiple ways to strategically create credit without applying for too many new lines of credit. Also, maintaining a good payment history can help improve your credit score and qualify you for loans with better interest rates.
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