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When it comes to your credit score, not all debt is treated equally.
Credit accounts come in many forms: credit cards, mortgages, auto loans, and student loans, to name a few. But did you know all of them can be classified into three distinct types of credit? Lenders look for evidence of each of these credit types in your credit report as proof you can manage various types of debt responsibly.
Having different forms of credit can boost your credit score — and lacking a good mix can hurt it. Here are differences between the three types of credit and how to use each to build a better credit score.
What Are the Different Types of Credit?
There are three main types of credit: installment credit, revolving credit, and open credit. Each of these is borrowed and repaid with a different structure.
- Installment credit: Installment credit is a type of loan in which you borrow one lump sum and repay it with interest in regular fixed payments, or installments, over a certain amount of time. Once an installment credit loan is paid off in its entirety, the account is considered closed. Examples of installment credit accounts include mortgages, auto loans, personal loans, and student loans.
- Revolving credit: Revolving credit accounts allow you to repeatedly borrow and repay amounts from a single line of credit up to a maximum limit. You’re in control over how much you borrow (and ultimately need to pay back). Interest is charged on any balance remaining after each statement’s due date, so it’s possible to avoid ever paying interest if you pay your balance in full each month. As long as you make all your payments on time, the account will remain open indefinitely until you choose to close it. Credit cards are the most common type of revolving credit, but HELOC (home equity line of credit) is another example.
- Open credit: Open credit is unique in that monthly payments vary, and balances are due in full at the end of each billing cycle. Your electricity bill is a great example of open credit; the amount due depends on how much electricity you used that month. You’re expected to pay the entire bill within a certain number of days after receiving it. Many utility bills — such as gas, electricity, water, cable, and cell service – are considered open credit accounts.
Less is more when it comes to establishing credit mix. While it’s good to show responsible use of different account types, you also need to weigh this benefit against the penalties for having too many accounts, which could easily harm your credit score.
How the Different Types of Credit Affect Your Score
Having different types of credit is an important part of your credit score as it shows lenders you can manage various types of debt responsibly. However, it’s not always clear how many accounts you need from each credit type in order to demonstrate the right mix.
“Consumers of any age and just about any income level can build their credit to a level most lenders consider ‘good’ with just two or three accounts,” such as credit card, car loan, or student loan, says Todd Christensen, education manager at Money Fit by DRS, a nonprofit debt relief organization. According to Christensen, results can come fairly quickly — “within a year or two so long as they make their payments on time, keep their card balances at $0, and pay down their installment loan balances as quickly as they can.”
Why Having a Variety of Credit Types is Important
Your credit mix is one of the smallest factors involved in calculating your credit score, making up 10% of the equation, but it’s still an important piece to watch out for. Lenders like to see a variety of credit types in your history because it shows that you’re capable of using all the different types of credit responsibly.
Having a good credit mix won’t help you much if you’re not making payments on time and keeping a low credit utilization ratio. If you’re already practicing good credit habits, it can provide the boost needed to take your credit score to the next level.
How to Apply This to Your Credit
While it’s generally not a good idea to take on debt for the sake of taking on debt, consider taking on an additional type of credit if you have a need for it and can pay it off.
If you’ve never had a credit card, it may be worth opening one and using it responsibly to help build your credit. However, be sure that you’re not making late payments, carrying a balance, or applying for too many credit cards at once, or those negative marks will wipe out any gains to your credit score from improving your credit mix.
The Bottom Line
Identifying the three types of credit is a skill that can help you plan your financial future better. Now that you know how the different types of credit work, take a look at your credit report and see if you can correctly identify each account type. You might be surprised to find you already have a more well-balanced credit mix than you originally thought.