You probably know credit as money you borrow to pay back later. Did you know there are three basic types of credit? Each type affects your credit score differently — in ways both good and bad. If you want to give future lenders a reason to lend you money, learn about each type of credit and how it affects you.
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Do you need all three types of credit?
There are three basic types of credit: revolving, installment, and open. If you have a mix of the three, you show lenders that you can responsibly handle a variety of obligations.
That doesn’t mean you need all three types of credit, though, and your credit mix accounts for a relatively small percentage of your credit score. Still, it’s worth understanding the different types of credit and how your credit mix may be helping, or hurting, your credit score.
Installment credit has fixed payments
Car loans and home equity loans are the two most common examples of installment credit. You borrow a set amount, and then you pay it off in fixed monthly installments. If you make the required payment each month, you’ll pay the loan off by the end of the agreed-upon term.
For example, say you borrow $20,000 to buy a car. You agree to pay $375 per month over five years (60 months). By the end of the term, you’d pay $22,500 for the $20,000 car. That extra $2,500 is the interest you paid.
You may be able to pay the loan off faster by making larger payments. Paying the loan off early may help you save on interest charges, as interest accrues daily. The faster you pay your outstanding balance down, the less interest you owe over the life of the loan.
Before you do this, read the fine print on your agreement, though. Some banks charge a penalty for paying the loan off early. This is how they ensure a minimum profit on your loan even if you pay it off sooner.
Revolving credit has a maximum credit line
Most people have experience with revolving credit in the form of credit cards. Other examples include home equity lines of credit and personal lines of credit.
Revolving credit gives you a maximum credit line — the total amount you can borrow. When you tap that credit line to spend money, the creditor assigns a minimum required payment that you must make each month until the amount you owe is paid off. You can pay the full balance or make the minimum payment and carry the balance over to the next month. If you carry a balance, though, you’ll pay interest on what you owe, and the interest rates on credit cards are exceptionally high. You should pay the balance in full if at all possible.
If you reach your maximum credit limit, you can’t use the credit line any longer until you reduce your balance. If you pay less than the full balance each month, your new balance will include not only the amount borrowed, but also accrued interest and any fees, such as late fees, cash advance fees, or balance transfer fees.
For example, if a credit card company gives you a $1,000 credit line and you spend $500 of it, you have $500 left to use moving forward. If you only make a minimum payment of $25 and the card has an APR of 19.9%, it would take you 25 months to pay the credit card off in full. At that rate, you would pay an extra $112 in interest charges for your initial $500 purchase.
Open credit requires lump sum payments
Charge cards (not credit cards) and utility accounts are two examples of open credit. Both types of accounts require payment in full, but otherwise they work a bit differently.
Charge cards are not revolving credit cards. A charge card may or may not have a set credit limit; it depends on your qualifying factors and the company providing the card. The amount you charge you must pay in full by the following month. If you don’t, you run the risk of hefty penalties or a closed account.
Utilities are a form of open credit, too — more specifically, a service credit. A utility company, such as an electric company, provides you a service up front. You then owe the cost of that service by the next due date. Utility companies expect you to pay the entire balance in full.
However, utility companies generally don’t report to the major credit bureaus unless you’re 30 days or more late on your payment. Then it becomes a negative mark on your credit report.
What credit scores are made of
Your credit mix accounts for just 10% of your credit score. The rest of your credit score is made up of the following:
- 35% – Payment history
- 30% – Amounts owed
- 15% – Length of your credit history
- 10% – New credit
As you can see, payment history is the largest piece of the puzzle. No matter the type of credit you have, you want to make your payments on time. Any payment you make more than 30 days past the due date counts as a late payment and can damage your credit score. Since this makes up 35% of your credit history, it can have quite an effect.
Maintaining a good credit score requires a delicate balance between timely payments, low outstanding revolving balances, a high average account age, and a decent credit mix.
If you have all three types of credit and use them responsibly, then yes, your credit score may benefit. If you don’t have all three types, you can still achieve an excellent credit score so long as you stay on top of your payments and don’t rack up excessive debt.
Put your focus on what you can afford. Don’t open credit accounts that you can’t pay on time or that you don’t need. Also try to keep any revolving balances (credit cards) at less than 30% of the available balance. Your credit utilization ratio (which falls under “amounts owed”) is the second-largest factor in your credit score calculation.
Opening a mixture of accounts shows lenders that you can handle all aspects of your finances. Showing that you can make minimum payments (or more if you can pay the balance in full), keep up with installment payments, and pay off open credit lines gives lenders a favorable opinion of you.
Keep a healthy mix of credit
Mix up your credit accounts and stay on top of each of them in order to maximize your credit score. If you have all three types of credit and use them responsibly, your credit score will benefit. Using them irresponsibly, though, may have the opposite effect. Make your decisions carefully.
View more information: https://www.fool.com/the-ascent/credit-cards/articles/the-3-types-of-credit-and-why-you-may-want-all-of-them/