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A diverse selection of loan products shows lenders how to handle different types of debt and can even help improve your credit score. Your credit mix counts as 10% of your credit score using the FICO scoring model that lenders use to determine if you are a good borrower.
The two most common types of credit accounts are installment credit and revolving credit, and credit cards are considered revolving credit. To get the best of both of them, you need to understand the terms, including the size of your monthly payments and how they will appear on your credit report.
Below, CNBC Select breaks down what you need to know about installment and revolving credit accounts and how they affect your creditworthiness.
1. Installment loan
An installment loan is a loan that offers a borrower a fixed or limited amount of money over a period of time. In this way, the borrower knows in advance how many monthly payments or “installments” to make and how much each monthly payment will be.
“Everything is spelled,” Jim Droske, president of credit advisory firm Illinois Credit Services, told CNBC Select. “You borrow a certain dollar amount on the loan, and the payments, interest rate, and term are all listed.”
For example, a bank can give you a 63-month loan to buy a new car. This essentially acts as a payment plan, meaning that you would make the same monthly payment for a specific 63 month period to pay off that loan and its interest. With every payment you make, your credit will decrease and at the end of the 63 months your loan will be paid off.
In addition to car loans, installment loans also include student loans and mortgages. The repayment deadlines for such installment loans can be months or years, depending on the loan conditions. You can opt for smaller monthly payments by agreeing to pay the loan over a longer period, or you can make larger payments over a shorter term. The ability to choose your repayment schedule is a helpful feature of an installment loan.
How It Affects Your Credit Score: Since every loan on your credit report is included in your credit history, it helps to have an installment loan to view a wide variety of credit accounts and increase the longevity of your credit history.
It is worth noting, however, that the actual balance of your installment loan doesn’t have much of an impact on your loan utilization rate or the ratio of your debt to the loan amount available. In fact, it’s okay in the eyes of lenders to have a high installment loan balance as long as the monthly payment isn’t too high for your income level. According to a VantageScore blog post (the other popular credit scoring model besides FICO), “You can easily have VantageScore credit scores well over 700, even with hundreds of thousands of dollars in installment debt. In fact, Prime consumers typically carry $ 100,000 to $ 105,000 in total debt. “
While this is true, it is important to consider the long-term costs of running large loans. The longer you are in debt, the more interest you will pay over time. While it may not hurt your score very much, keep in mind that you will be paying the loan until it is paid off.
However, installment loans are easier to budget because the monthly payments are predictable. As long as you make your scheduled monthly installment loan payments on time, your credit score will improve. Payment history makes up 35% of your FICO score calculation, so it’s important not to miss any due dates.
2. Revolving Credit
In contrast to the installment loan, the revolving loan grants the borrower a line of credit with no set end time, which he can spend up to his assigned credit limit.
“It’s an ongoing ‘open’ loan commitment,” says Droske.
The greatest example of revolving credit is a credit card; the cardholder routinely charges, pays all or part of it, charges more, and so on. The amount of money the borrower uses within their credit line is up to them and there is no fixed monthly payment plan. The borrower has the option of paying off their balance in full each month (which we recommend) or they can just pay the minimum and carry over or “revolve” their balance to the next month (which usually means interest is charged).
How It Affects Your Credit Score: Likewise, with the installment loan, it is important that you pay your monthly bill on time in order to have the best creditworthiness. And ideally, you pay out the balance every month. Revolving loans have a huge impact on calculating your credit utilization, which is the second largest factor (after payment history) that determines your creditworthiness.
Experts generally recommend borrowing or using less than 30% of your credit line. If you keep paying off your revolving balance, your credit score will go back up as you free up more of your available balance.
This is how you avoid having to pay off revolving debts
You should aim to never have credit on your credit card month-to-month as you will accrue interest that can get expensive quickly.
When looking for a new credit card, consider one with an introductory period of 0% APR. Most zero interest credit cards require good or excellent credit in order to qualify. So check your creditworthiness before applying.
For those with good credit, the Wells Fargo Platinum Card offers zero interest on purchases and qualifying credit transfers for the first 18 months (16.49% to 24.49% variable APR thereafter). The card also comes without an annual fee.
For those with good or excellent credit and also looking for rewards, Chase Freedom® offers no interest on purchases for the first 15 months (after that 14.99% to 23.74% variable APR). The card has no annual fee and new cardholders can earn $ 200 cashback after spending $ 500 on purchases in the first three months. Chase Freedom has a rotating rewards program that offers 5% cashback on up to $ 1,500 in combined purchases in bonus categories (then 1%) and 1% cashback on all other purchases each quarter you activate. From July through September, the cash back bonus categories include Amazon.com and Whole Foods Market.
Do not miss: Revolving credit debt drops to $ 996 billion – its lowest level since the great recession
Information about the Wells Fargo Platinum Card and Chase Freedom® was independently collected by Select and was not verified or provided by the card issuer prior to publication.
Note to editors: Opinions, analysis, reviews or recommendations expressed in this article are solely those of the Select editors and have not been reviewed, approved or otherwise endorsed by third parties.