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The Big Three: Different Types of Credit

The Big Three: Different Types of Credit

The concept of credit is relatively simple: A borrower receives money or goods now with a promise to pay a lender back later, typically with interest to compensate the lender. But credit is not just a single monolithic thing. Did you know there are actually three main types of credit that show up on your credit report and are used to calculate your credit score?

Understanding the difference between the different types of credit can help you to make better decisions on which types to use and how using each of the three could affect your credit score, an indication of your creditworthiness to potential lenders.

CREDIT TYPE #1: INSTALLMENT CREDIT

Installment credit is when you borrow a specific amount of money from a lender and agree to pay off the loan in regular payments of a fixed amount over a specified time period. Home mortgages, car loans, and student loans are the most common examples of installment credit.

A typical car loan checks all of the boxes of installment credit. Say you borrow $25,000 from a bank or auto finance company to purchase a car, and you agree to pay it off in payments of $500 per month over a period of five years. The $25K represents the specific amount you’re borrowing, $500 is the fixed amount you’ll pay regularly (monthly), and the specified time period is five years.

Of course, when it’s all said and done, you’ll actually pay $30,000 ($500 per month multiplied by 12 months per year multiplied by 5 years) for that $25,000 car. That’s because of the interest, the amount of money the lender is charging you for the privilege of borrowing the money. On a car loan, the interest is typically a fixed rate; however, it can vary over time on other types of installment loans, such as home mortgages. You can usually save on interest by paying installment loans off early, but some may have an early payment penalty associated with them.

CREDIT TYPE #2: REVOLVING CREDIT

If you’re granted revolving credit, it means a lender has extended you credit, up to a certain amount, that you’re free to use repeatedly—so long as the account remains open and you make regular, on-time payments of at least the minimum amount due. Credit cards are the most common type of revolving credit, along with department store and gas cards and home equity lines of credit, loans that allow you to borrow against the value of your home.

Unlike installment credit, which is over and done once you’ve paid back the principal plus any interest owed, revolving credit stays open for you to use over and over again—so long as the account is in good standing. So, if you have a credit card with a $500 limit, and you charge $300 on it over the course of a billing cycle, you don’t just have another $200 in credit available to you for the life of the card. So long as you keep making required payments, you’ll continue to have credit available to you on that account.

The amount of credit you’ll have available depends on how much you pay. If you pay the outstanding balance in full, you’ll have the full $500 available to you for the next billing cycle. If you don’t pay the balance in full, you’ll have less than your full credit line available to you, plus you’ll be charged interest on the outstanding balance you’re carrying.

CREDIT TYPE #3: OPEN CREDIT

This type of credit contains elements of both installment and revolving credit. With open credit, the amount due is usually different each billing cycle, and that amount is typically due in full. A utilities account—gas, electric, water—is a good example of open credit. The amount you owe each month will vary, depending on how much of the commodity you actually use, and the entire balance is expected to be paid.

Charge cards are another example of open credit. Unlike a credit card, which has a set credit limit, charge cards do not have a preset limit. This doesn’t mean they have no limit; just that the limit may fluctuate frequently over time, depending on your spending patterns, payment history, credit score, and other factors. Of course, credit card limits can change as well—such as when you receive a credit line increase—but typically much less frequently than with a charge card.

The other main difference between a credit and charge card is that you are expected to pay off the entire balance of a charge card each billing cycle. If you don’t, expect to be hit with significant fees or to even have your account closed if it happens too often. American Express is probably the best known charge card. Some department stores and gas stations issue charge cards as well, although credit cards are much more the norm these days with both.


HOW DIFFERENT TYPES OF CREDIT AFFECT YOUR CREDIT SCORE

Each of these three types of credit plays a role in determining your credit score. While there are two main credit scoring models—FICO® Score and VantageScore®—we’ll focus on your FICO Score for this discussion, which is calculated using the following five categories:

1. Payment History (35% of your score)
A history of making consistent, on-time payments makes up the largest percentage of your FICO Score. All three credit types—installment, revolving, and open—contribute to this category, so it’s important to make sure you pay at least the minimum amount due on time regularly for every loan, credit card, or charge card you have open.

2. Amounts Owed (30% of your score)
This category isn’t just concerned with how much you owe; it focuses on how much you owe as a percentage of your available credit, also known as your credit utilization ratio (CUR).

CUR = SUM OF REVOLVING CREDIT BALANCES OWED ÷ SUM OF REVOLVING CREDIT LIMITS

As the above equation indicates, only revolving credit is used in your credit utilization ratio calculation, so how you manage your credit cards has a major impact on your credit score. Many experts recommend maintaining a CUR of 30% or less.

Charge cards are not included in calculating this ratio because they do not have a preset credit limit. They can, however, be influential in helping to maintain a healthy CUR. If you plan on purchasing an expensive item that would raise your CUR if bought with a credit card, using a charge card instead will not raise this ratio and possibly cause your credit score to take a hit. If you do put it on your charge card, be sure you’ll have enough money in the bank to pay for the item when your payment is due, because charge card balances must be paid in full each billing cycle.

3. Length of Credit History (15% of your score)
All three types of credit factor into this category. Installment loans close once they’re paid in full, but if you’ve had a credit or charge card for some time, it can help your credit score by keeping it open, even if you don’t use the card very often. Closing it could lower the length of your credit history, which could negatively affect your credit score.

4. Credit Mix (10% of your score)
Your credit mix is where utilizing all three types of credit really pays off. It may only make up 10% of your FICO Score, but potential lenders do like to see that you can handle a variety of credit responsibly.

5. New Credit (10% of your score)
New credit is also only 10% of your FICO Score, but lenders like to see how much new credit you’re taking on, as too much too soon could be an indicator you’re not doing well financially. This category includes all three types of credit, so if you’re considering getting a car loan, opening a new credit card, and signing up for a charge card, you may want to space them out so you don’t have too much new credit too soon showing up on your credit reports.

As you progress through life, your credit needs—and the mix of credit types you maintain—will undoubtedly change. But it’s important to have some understanding of the different types of credit, and how they affect your credit score, no matter whether you’re young or old or in between. Doing so should help you get the most out of your credit at every stage of your life.


 

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This material is for informational purposes only and is not intended to replace the advice of a qualified tax advisor, attorney or financial advisor. Readers should consult with their own tax advisor, attorney or financial advisor with regard to their personal situations.
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