If you are a regular reader of our blogs, you would have learned, by now, what credit is and the benefits of good credit over bad credit. And that’s an excellent start. To recap, credit is simply defined as “a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at a later date—generally with interest.” But did you know that credit is not a broad singular term, and that there are three different types of credit? We must ask, then, What are the three types of credit and do they matter? To answer most simply: Yes, yes, and yes. All three types of credit matter and it’s time to learn why.
The three types of credit
The three types of credit are revolving credit, installment credit and open credit. Now, though all three types of credit differ, it’s actually good to understand and have a mixture of all three. When you have all three it sends a strong message to creditors and lenders that you are financially responsible. It also shows them that you can handle diverse financial commitments.
To be clear, you do not need to have all three, necessarily. But it is good to understand if there are benefits to you for having them. Knowing that it is in your financial interest to have these types of credit, we should ask an important question. Do all three types of credit affect your credit score? The simplest answer is, Yes, they do.
How is your credit impacted?
Installment credit, revolving credit and open credit are all going to affect your credit score, if you miss payments. In fact, missing payments on these types of credit can drop your credit score. Late payments will undoubtedly cause a decrease in your credit score and should be a major area of focus when attending to your credit.
Did you know, the factor that has the largest impact upon your credit score is your payment history. Your management of your payment history will make up 35% of your FICO credit score. Our simple chart below breaks down the credit impact factors by percentage.
As you see here, a number of factors can impact your FICO credit score in negative ways. Your FICO Score is a three-digit number based on the information in your credit reports, and it is what lenders use to analyze your credit worthiness.
Revolving credit accounts
We most encounter revolving credit though three main points of contact:
• Credit cards
• Home equity lines of credit (HELOCs) and
• Personal lines of credit
The basic points to remember about this type of credit are that it offers customers access to funds from a financial institution. And it has a set credit limit that a customer pays off. Customers have access to a predetermined amount of funds (which is their credit limit).
When you pay down on your revolving credit, that money is now available for use again. If assets are secured for your revolving credit, note that the bank can seize those assets if your debts are not paid off in a timely manner. Note, as long as you use them responsibly, revolving credit accounts will stay open until you close them.
Revolving credit limitations
As stated, with this type of credit your limit is the total amount you can borrow, also known as your line of credit. Generally, your creditor will set the amount you must pay each month to pay off your debt. These usually carry higher interest rates and, ideally, should be paid off in full as soon as possible. If you are unable to pay your balance in full, you can expect to accrue various fees from month to month. These fees will differ in severity and type from institution to institution.
Installment credit is quite different from revolving credit. The easiest way to remember it is that installment credit has a predetermined length and end date, which is known as the term of the loan. It also has a set schedule in which the principal is gradually reduced through consistent payments. This is known as an amortization schedule.
Some common types of installment credit we access are mortgage loans, auto loans, personal loans, and student loans. In each of these examples, you make fixed monthly payments toward a set amount that was borrowed. Once a borrower makes the agreed-upon monthly payments, the loan will be paid off by the end of the agreed term.
In some instances, though, banks may charge a penalty for paying off a loan quicker than the agreed-upon period end date. It’s always important to read the fine print to make sure if these type of penalties can be incurred. If not, then Empowering the Possibilities recommends that you pay off the loan as soon as you can. When you do, this can save you on some of those interest charges you would have accrued on this loan. You can read our post, how to reduce your credit card debt, for some additional insights.
The last type of credit we will look at is open credit. According to the Corporate Finance Institute, “open credit is a pre-approved loan between a lender and a borrower,” that “allows the borrower to make repeated withdrawals up to a certain limit” and make repayments before payments are due.
One popular type of open credit is a charge card. Investopedia defines a charge card as one that charges no interest but requires users to pay their balances in full upon receipt of statement. They do carry annual fees though. Charge cards are branded and are available to use as payment wherever the branded card is accepted.
To see a comparison of some of the best charge cards of 2020, Nerd Wallet does an exceptional comparison of charge card fees and minimum credit scores needed to secure them. When using the cards wisely, one can easily strengthen their credit scores by making the full payments. In fact, on-time payments are key to maintaining a healthy credit score.
Keep in mind that not only negative activity can affect your score but positive activity can as well. Its at this time it is so important that your lender reports positive payments. If you’re not checking, you’re wasting an opportunity to build credit.
Is it important to have different types of credit?
By now, we have learned of the different types of credit and can assuredly say, Yes. Consumers should have at least two types of credit for the most part. If you are working towards building up your credit score, you should have both revolving credit and installment credit.
As shown, having account variety (i.e., your credit account mix) will make up about 10% of your credit score. By doing so, you are showing creditors and lenders that you can maintain and manage diverse accounts.
Lenders look to see if you’re responsible in managing different types of credit. And this type of activity, for example managing a mortgage, personal loan and credit card, helps them get a clearer image of your ability to pay back debt. In sum, creditors look at you favorably when you can make their balance repayments, handle installment payments, and make the lump-sum payments of open credit lines.
Whether having one, two or all three types of credit, if you use them responsibly your credit score will increase. With this knowledge that all three types of credit do matter, we encourage you to empower your financial possibilities by choosing and using them wisely.