Banks offer a variety of different loan products that you can use when you're trying to establish or repair credit. These includes revolving accounts such as credit cards, as well as installment loans such as car loans or student loans. Revolving debts have more of an impact on your credit score than installment loans. Depending on how you manage your finances, that may or may not be good news.
Credit scores are like grades that you receive for managing your debts. The scores are calculated by firms known as credit bureaus, and these include Equifax, Experian and TransUnion. You don't have a credit score until you begin using credit. From that point forward, your credit score may change on a monthly basis. If you pay your bills on time and keep your debts to a manageable level, then you earn a high score, with 850 being the highest score. If you pay your bills late or not at all, then your credit score can fall to as low as 300. It's generally difficult and more expensive to borrow money if your score drops below 600.
Types of Loans
Installment debt is any type of loan that you repay in installments. Traditional car loans are installment loans, as you make monthly payments for between two and 10 years until you've paid off the entire loan balance. With an installment loan, some of each payment goes toward covering interest while the rest is used to pay off the principal, which is the sum of money you actually borrowed. In contrast, revolving debts are accounts such as credit cards that you can use and pay off multiple times. With revolving debt, your payments change from month to month and you have the option of making interest-only payments.
Credit bureaus monitor your payment activity, and this accounts for about a third of your overall credit score. When you make on-time payments on credit cards and installment loans, your credit score rises. If you miss a payment date by 30 days or more, then your credit score drops. Your credit score drops even further if you fall 60, 90 or 120 days behind on your payments. In terms of payment history, revolving debts and installment loans are equal. This means a late payment on your credit card hurts your credit score just as much as a late payment on a student loan.
Your credit report includes details about the balances you owe on credit cards, car loans and other types of debt. Your overall debt level has an impact on your score. If your debt level is high compared with your income, then your score may suffer. However, credit bureaus take this analysis a step further by calculating your revolving debt balances as a percentage of your available credit. Your score suffers if you use all of your available balance because this suggests that you rely on your credit cards to cover day-to-day costs. In contrast, credit bureaus don't calculate the percentage that you owe on installment loans because these loans have a fixed end date.
If you don't use your revolving accounts at all, then you don't really help or hurt your score because your creditors have nothing to report to the credit bureaus. On the other hand, your revolving balances stay low, which helps your score. You get the best of both worlds if you use your credit cards but keep your balances below 35 percent of your available credit. You could use your credit card in this manner simply to build your score. You can't do the same thing with installment debts, so you could argue that revolving debt helps your credit score more than installment debt. While arguably true, revolving debt can hurt your score more than installment debt if you max out your credit cards.
- MyFICO: What's in My FICO Score?
- Experian: Defining "Revolving" Trade and Other Credit Report Terms
- Experian: Credit Score Hurt by Lack of Revolving Accounts
- Experian: Balance-to-Limit Ratio Applies Only to Revolving Accounts
- Forbes: Small Business, Bad Credit and Fixing It in a Single Bound
- Bankrate.com: It's Buyer Beware on Subprime Loans
- George Doyle/Stockbyte/Getty Images