Your credit score is calculated using a complex algorithm based on a number of factors. In order to improve your credit score, it’s important to understand how credit bureaus determine it so that you can take strategic actions to improve it.
FICO Credit Scoring Model
FICO scores, the most commonly used credit scoring model in the nation, uses five different categories to determine your creditworthiness:
- Payment history
- Amounts owed
- Length of credit history
- New credit
- Types of credit
Most of those categories are pretty self-explanatory. However, many consumers are unfamiliar with the different types of credit and how they affect credit scores.
The ‘types of credit’ category constitutes 10% of your credit score. The different types of credit include revolving, installment, and open accounts.
We’ll show you why having a balanced mix of accounts is important and what each different type of credit account entails. Then we’ll give you action-oriented steps to maximize your credit score in this category. Let’s get started.
Why is having different types of credit important?
Despite only contributing 10% to your FICO score, different types of accounts are an important component in determining that final number, particularly if your credit history is limited.
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 credit report, a lender can get a pretty good idea of your potential credit risk. But if you have little or no credit, it becomes more difficult. In these situations, lenders look more closely at your credit mix.
This may raise eyebrows because lenders will see that 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 scores.
Types of Credit Accounts
Now that you understand why credit mix is important, it’s time to learn exactly which ones are available to you as a consumer.
Credit comes in three different forms: installment, revolving, and open. While each type can affect your credit scores in different ways, most financial experts agree that it is best to have a healthy mix of each one.
What is an installment account?
Installment credit refer to 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.
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).
What is a revolving account?
Revolving credit accounts do not have a pre-determined payment schedule. The most common example of this is a credit card.
With a credit card, you have a set credit limit of how much money you may borrow. However, 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 card 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.
Estimates show that over 72% of Americans carry at least one credit 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. Cardholders usually receive some sort of perk, like additional discounts or coupons. Gas cards are also considered revolving credit.
If you’re struggling to get a credit card because of poor credit, you may want to consider getting a secured credit card to get started.
Home Equity Lines of 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.
What is an open account?
Open accounts essentially combine 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. Examples of open accounts are utility bills such as electricity, gas, water/sewage, garbage, internet, and cable TV.
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.
Paying your open accounts on time each month, unfortunately, doesn’t help your credit. However, not paying them does hurt your credit scores. A utility or cell phone company doesn’t regularly report on-time payments. However, they will almost certainly report delinquencies. Past due accounts are usually reported when they are late by 30 days or more.
Why do I need various credit types?
There’s no one-size-fits-all solution to improving 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 credit mix of your credit reports.
Installment loans, for example, can help your credit because they build up a positive payment history. This shows lenders that you are a reliable borrower.
Additionally, some types of installment credit is 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. However, a car loan is sometimes viewed as “bad credit” because the vehicle’s value depreciates quickly compared to the loan amount.
How much credit is too much?
Lenders don’t want to see too much revolving credit being used 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.
First of all, closing old accounts won’t automatically make them go away on your credit report. And second, closing old credit card accounts can actually hurt your credit score.
Getting Your Credit Mix Right
There is no specific formula to get the perfect balance of “credit mix”. While it’s good to maintain a diverse credit mix, 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.