Your credit score is calculated using a complex algorithm based on a number of factors. In order to increase your credit score, it’s important to understand how credit bureaus determine that magical number so that you can take strategic actions to improve it. FICO scores, the most commonly used credit score in the nation, uses five different categories to determine your creditworthiness: your payment history, the amount you owe, the length of your credit history, new credit, and the different types of credit available to you. Most of those categories are pretty self explanatory, but many consumers are unfamiliar with the meaning of “different types of credit” and the impact it has on their credit scores.
Accounting for 10% of your credit score, the category for different types of credit takes into account the types of credit you use, which includes revolving, installment, and open accounts. We’ll show you why having a balanced mix of accounts is important to your credit score and what each different type of account entails. Then we’ll give you action-oriented steps to maximize your score in this category. Let’s get started.
Why is having different types of credit important?
Despite only contributing 10% to your FICO credit score, different types of credit is an important component in determining that final number, particularly if your credit history is limited. Remember that the purpose of both your credit score and your credit report is to help lenders ascertain how much of a risk you pose if they lend you money. Are you likely to default on the loan, or are you probably going to make consistent payments on time each month?
If you have a lengthy credit history with multiple items on your report, a lender can get a pretty good idea of your potential credit risk. But if you have little or no credit history, it becomes more difficult. In these situations, lenders look more closely at your different types of credit: do you have a lot of credit cards, but no installment loans? This may raise eyebrows because lenders will see you can charge expenses, but you may not have a history of regular payments on other types of loans. While every individual’s situation is different, it’s typically considered better to have a diverse variety of accounts to increase your credit score.
What is the difference between each type of credit account?
Now that you understand why having different types of credit is important, it’s time to learn exactly what types of credit are available to you as a consumer. Credit comes in three different forms: installment, revolving, and open. While each type can affect your credit score in different ways, most financial experts agree that it is best to have a healthy mix of each one.
Installment credit is a type of loan that allows you to borrow a fixed sum upfront, which you repay regularly over time. Your payment is the same each month and is spread out over a specified length of time. The lender charges you interest on the borrowed amount, which is included in your monthly payment. Interest rates can either be fixed or variable. If it is fixed, you’ll pay the same interest rate for the life of the loan. If it’s variable, your interest rate — and, consequently, your monthly payment — may fluctuate up or down based on market conditions.
Installment loans are often (but not always) used for major purchases that would otherwise be unattainable for most people if they had to pay cash. A common example is a mortgage. The median home sale price in the US for March 2016 was $222,700. Few people would be able to save up that cash to buy their own home so they take out a mortgage — which is an installment loan. Each month your payment goes partially towards your principal balance and partially towards interest, typically for 30 years (although 15-year mortgages are also available).
Car loans, student loans, home equity loans, and personal loans are also examples of installment loans.
Unlike installment credit, revolving credit does not have a pre-determined payment schedule. The most common example of this is a credit card. You have a set limit of how much money you may borrow, but you determine how much of the balance you wish to pay each month — the minimum or more. The name comes from the ability to revolve your balance to next month’s bill. You can use your credit repeatedly, but are charged interest on the amount you borrow. Your available credit decreases the more you spend, and subsequently increases again as you pay off your balance.
Credit cards have become fairly ubiquitous in this day and age. Estimates show that over 72% of Americans carry at least one card, whether it’s Visa, MasterCard, American Express, Discover, or less common brands. Other types of credit cards include those from retailers, which can only be used at that specific store. Card holders usually receive some sort of perk, like additional discounts or coupons. Gas cards are also considered revolving credit.
But revolving accounts don’t just include credit cards. A home equity line of credit (also referred to as a HELOC) lets homeowners access their home equity without taking out a lump sum all at once. Instead, you receive a line of credit from your bank or credit union. Similar to a credit card, you take out money as you need it, and only then does that amount begin to accrue interest. Since you’re using money from the equity in your home, you can usually claim the interest as a tax deduction. As you borrow money from the HELOC, you begin to repay it as you would a credit card balance and your available credit goes back up.
Open credit essentially combines the two concepts of installment and revolving credit. Your monthly payment varies each month and you must pay it in full rather than carrying a balance over to the next month. An example of an open account is your utility bill. Your bill varies depending on your usage each month and you’re obviously expected to pay the entire amount by the due date. Cell phones and some types of company charge cards are other forms of open credit.
While paying your open accounts on time each month unfortunately doesn’t help your credit score, not paying does hurt your score. A utility or cell phone company doesn’t regularly report on-time payments, but will almost certainly report delinquencies. Past due accounts are usually reported when they are late by 30 days or more.
How can you increase your credit score with different types of credit?
There’s no one-size-fits-all solution to fixing your credit score, but it can be helpful to have a diverse mix of credit types. This shows lenders that you don’t rely on just one type of credit, especially credit cards. Lenders might also make a few other assumptions based on the types of credit accounts on your report.
Installment loans, for example, can help your credit because they build up a positive payment history, showing new lenders that you are a reliable borrower. Additionally, some types of installment loans are considered “good credit.” A mortgage for example, typically indicates you are building equity that you could potentially later tap into. Student loans might make a lender think that your long-term earning potential is higher because you have a college degree. But not all installment credit is considered good. A car loan is sometimes viewed as “bad credit” because the vehicle’s value depreciates quickly compared to the loan amount. On the plus side for all installment loans, they very often offer lower interest rates than credit cards.
Lenders don’t want to see too much revolving credit because it could indicate you are in financial distress and often need quick access to money. However, that doesn’t mean you should immediately close extraneous credit cards because that won’t automatically make them go away on your credit report. Delinquent accounts will remain on your report for seven years after the first missed payment, even if it’s paid in full and closed out. This obviously hurts your credit score. On the other hand, if you had a positive payment history, the account will stay on your report for ten years, giving your credit a boost.
While open credit accounts won’t help your credit score, paying your bills on time each month is a good defensive strategy to prevent your score from decreasing. Always prioritize your budget to first cover necessities like your rent or mortgage, utilities, and cell phone bill before spending your money on discretionary items like entertainment.
Getting your credit right
There is no one formula for everyone to get the perfect balance of different types of credit. While it’s good to maintain diverse accounts, you shouldn’t take out a loan just for the sake of adding an installment loan. You might, however, consider transferring credit card debt to a personal loan if you can get a lower rate. Think creatively about how you can simultaneously repair your credit and save yourself some cash in interest payments.