When it comes to credit, you shouldn’t just stick your head in the sand and hope things work out. While the topic can be confusing, complex and even a little scary, knowing what’s going on with your credit can help you make the best financial decisions for your situation.
One aspect you should know about is the difference between installment credit and revolving credit as well as what both types of debt mean for your credit score.
What Is Installment Credit?
Installment credit is likely what comes to mind when you think of the word “loan.” An installment account is one where you borrow a fixed amount of money and then make regular payments of a specific amount on the loan until you’ve paid it off. If you want to borrow more money, you have to apply for another loan.
Examples of installment type loans are car loans, mortgages and student loans.
What Is Revolving Credit?
Revolving credit is marked by the ability to continue to borrow from a line of credit. You have a maximum amount of money you can borrow at one time, and you continue to borrow and pay interest on what you owe until you hit that limit, at which point you’ll need to pay down some of your debt to free up your credit line and continue borrowing.
The classic example for this type of credit is a credit card. With a credit card, you’re given a credit limit (or credit line), and as long as you keep up with your payments and stay below your limit, you have credit available to you and can continue borrowing.
How Do These Different Types Affect Me?
It’s important to know about both of these types of credit and how you can make them work for you, as borrowing money and paying it back in a timely manner is part of how you build your credit history and establish a good credit score.
Every time you make an on-time payment on a debt you owe, you’re building good credit, whether you’re making payments on an installment debt like a student loan or paying off a revolving debt like a credit card.
However, there are some differences between these two types of debt and the ways they can affect your credit score.
Installment credit allows you to build a solid, stable credit history because you’re making regular payments over a set amount of time. As long as you’re making payments on time and in full, there isn’t a lot of room for error with these types of loans.
Since payment history is the biggest factor in determining your credit score, installment loans can be a good way to build a strong credit history.
However, too much installment debt can be a bad thing. Aside from having a lot of monthly payments to deal with, borrowing money increases your debt-to-income ratio (DTI).
Your DTI is the sum of all your minimum monthly payments for all the loans you owe money on (including car loans, student loans, credit cards, mortgages, etc.) divided by your gross monthly income.
If your DTI is too high, you won’t be able to qualify for a mortgage. Lenders generally look for a DTI of less than 50%.
Revolving credit offers more opportunities to impact your credit score – for better or for worse.
With revolving credit like a credit card, you have to keep an eye on your credit utilization ratio. After payment history, utilization is the second most important factor in determining your credit score.
Your utilization rate is calculated by looking at the amount of money you currently owe in revolving credit and dividing that by your total credit limit. For example, if you have one credit card with a limit of $2,000 and you currently owe $1,000, your utilization rate is 50%.
To avoid negatively affecting your credit score, experts recommend keeping your utilization below 30%.
Having a good mix of revolving accounts and installment accounts factors into your credit score, so it’s not a matter of using one or the other. In fact, you’ll probably find you need to utilize both throughout your life to help manage your finances.
What Are the Possible Pitfalls?
You’re probably already aware of the many problems that debt can cause for people.
Whether it’s large student loans, credit cards with high interest rates or hefty monthly mortgage payments, it seems like everyone these days is struggling to keep from drowning in debt.
One of the main pitfalls that comes with struggling with debt is damage to your credit score. If you’re unable to make payments or find yourself continually racking up charges to your credit card, your credit score is going to take a hit. This can take a long time to recover from.
However, missing payments doesn’t just hurt your credit. If you borrowed money to buy your house or your car, those assets are put at risk when you aren’t able to make payments on those loans. You could end up having your house foreclosed on or your car repossessed.
You can also end up getting caught in a cycle of debt, where you’re taking on more debt to try to pay off what you currently owe and the amount of interest you owe continues to grow until it’s out of control.
Whether or not your various credit accounts become more of a hindrance than a help comes down to whether you’re able to make on-time payments and keep your utilization down.
So, is one type better than the other? Not necessarily. They’re just used for different things. Installment credit like a car loan or a mortgage can make financial goals more achievable, while revolving credit can help you manage your finances by allowing for easier payments and offering better consumer protection than other forms of payment. Revolving credit, when used carefully, can also be a great tool to help you build a good credit score, which unlocks the door to being able to buy a home one day.
Managing your finances and credit can be tricky, but it doesn’t have to be. With Rocket HQ℠, you can see your credit report and score, monitor your credit, and have access to plenty of educational tools and resources that can help you make better financial decisions.
To get started, head over to Rocket HQ℠.
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