There are three specific types of credit that you need to be aware of when you start to build your credit file. This is important because you will also want to know what is a good mix of credit on your credit report.
The three types of credit available to most consumers are:
- Revolving – Credit Cards and Credit Lines
- Installment – Auto Loans and Mortgages
- Open – Charge Cards paid off monthly
Revolving Credit
Revolving credit allows you to continue to use a credit card or credit line. Once you pay off some or all the debt, your credit line is replenished and not closed. This will allow you to maintain a credit line as a tool to make purchases as you see fit. The more you pay off the more available credit you have.
Credit cards are the great example of this. I have a credit card, let’s say I charged $400 against my credit limit of $1000. During that month, I will only have $600 of available credit until that is paid back. Once I pay it all back I will then have access to the full $1k credit line. If I make smaller payments, then those principle payments will be added back to my available credit.
Let’s say I have a $10k credit line and I use it to buy a car. As I make payments towards the principle of the credit line, I am able to access that credit again at any time. Once it is paid off the credit line will remain open for future purchases.
Installment Credit
Installment credit is when you borrow a set amount of payments to be paid back in a certain amount of time. A great example of these are auto loans and mortgages. Once the loan is repaid then the account is closed.
The benefits of installment credit are that you know exactly what your payment is each month and the principle and interest charges do not change as long as it has a fixed rate.
Open Credit
Open credit is something that is not really used any more today by consumers. It used to be you could have a store charge card or account and then pay it off every month. There is not interest rate or payments unless the consumer defaults. The balance must be paid in full every month.
When we had our own business we used to have this type of credit. We had an open account with a local gas station where our employees could get gas and charge our account. With this type of account, we could manage our cash flow. It also allowed us to see all of our expenses with charge accounts in one neat statement, The best part was we did not have to hand one of our credit cards over to an employee.
Now credit card companies offer employee credit cards with low limits with more control and monitoring for the business owner.
Why Is Knowing The Three Types Of Credit Important For My Score?
According to the FICO Score modeling system, one of the 5 factors in determining your credit score is Credit Mix. It will account for 10 percent of your score. Although this is not a huge factor, you will still want to address it in your long game of credit restoration.
Lenders also want to be able to see that you can handle many types of credit. Someone who only has had one credit card and no other types of credit will have a lower score than someone who has a variety. The person may also have more credit history, available credit, etc. just from the sheer fact that they have multiple types of credit accounts.
On the other hand, if you have multiple late payments and a good mix of credit, your credit score will be significantly lower than the previous scenario.
Remember, payment history represents 35% of your FICO Score. Making late payments means a much harder hit to your score over not having a good credit mix. Payment history is the most important factor in raising your credit score.
Why Do The Three Types Of Credit Matter When I Apply For Credit?
The types of credit do not just affect your credit score. Lenders will often require that you have a certain amount of trade lines on your credit report in order to qualify for a loan.
It is also important to the lender that you have experience with more than one type of credit. Your credit score may qualify but you may not have the other credit qualifications they are looking for.
Lender Guidelines
Here is an example of some lender guidelines from an auto lender:
- A minimum credit score of 640
- 25% Monthly Debt vs. Monthly Income Ratio. (Payments vs Income)
- Two trade lines with a minimum 24 month history or 3 trade lines with a 12 month payment history.
- One trade line has to be a previous auto loan that has been paid as agreed.
Adding additional guidelines to a loan helps to protect the lender but still allows them to lend in certain situations. This borrower has a lower credit score and may not qualify for a top rated loan. By showing that they are able to pay off an auto loan, the lender is more comfortable lending to the borrower.
The lender wants to structure their guidelines to fit a particular profile of the type of borrower they want to lend to. Many consumers have very little knowledge of lender guidelines. So it is important that you know going into an application process what they are looking for before you add a hard credit inquiry on your credit report.
Should I Start Applying For Different Types Of Credit?
Not necessarily. If you have your initial two or three credit accounts, I would only apply for new credit as I need it. Too much available credit, too many credit inquiries and too much debt can hurt your score as well.
If a lender sees multiple credit inquiries, that may indicate financial distress. You may be declined regardless of the circumstances.
If you are just starting out, I would recommend you get used to having credit with one credit card and getting used to making the payments or paying it off each month. Once you have gotten more experience with managing your finances, then I would add more types of credit to your file to help raise your FICO Score.
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