While regular consumers regularly hear the terms installment credit and revolving credit thrown around, it's critical to distinguish between the two to maximize their credit score. Installment credit is regularly associated with mortgages and auto loans and revolving credit is connected with credit cards. By learning more about these credit categories, you could help maintain a good credit score and a healthy balance of various credit types in your credit history.
What is the Definition of Installment Credit?
For installment credit, a creditor will give you a loan for a certain amount of money that you will pay back during a fixed period of time. The amount you owe per month tends to be same month over month.
Installment credit includes:
- Auto loans
- Student loans
For example, in the case of student loans, you may sign an agreement to pay what you owe by sending a check for $200 per month in a 30-year repayment period. For many consumers, their first interaction with credit is with student loans, or a type of installment credit. Installment loans could be a good first step to building your credit history as they may be easier to manage because there is a fixed amount you will pay each month.
Different Types of Installment Loans
With a wide range of credit obligations included in installment credit, there are also two categories these types of loans tend to fall under: secured loans and unsecured loans. The difference between the two describes the risk the loan is to creditors. An unsecured loan is considered the more risky of the two, resulting in a higher interest rate compared to a secured loan.
While a secured loan has a lower interest rate, there is also the possibility that the creditor may have to may repossess and sell personal assets in the event you cannot pay back the loan.
What is the Definition of Revolving Credit?
Revolving credit is when a creditor provides you with a maximum credit limit. Unlike with fixed payments of installment credit, you have greater flexibility in choosing how much to put toward repaying your charges, whether they are the minimum or full payment. You can choose to pay the balance in full or you can carry over the balance and these payments happen in continuous cycles, hence the term revolving credit.
Types of revolving credit include:
- Credit cards
- Home equity lines of credit
Importance of Having Both Types of Credit
As part of how credit score providers calculate your score based on credit history, one of the most important factors is being able to have a mix of credit types. This is why it's important to have both installment and revolving credit to demonstrate that you can juggle various credit commitments. After you show that you can pay on the balances on your credit cards, a mortgage and more, creditors could view you as being responsible enough to take on a new line of credit.
Which Type is Better in Improving Your Credit?
In establishing a credit history with both types of credit, your score could see huge improvements. However, how much they impact your credit are dependant on how you manage them. According to Experian, a revolving credit account may be more effective in showing creditors that you can manage your credit in a responsible manner. If there is an absence of revolving credit in your credit history, then you may not be able to raise your score as high as it could be with both installment and revolving credit. On the other hand, since it is harder to obtain a mortgage than a credit card, an installment loan in the form of financing for a home could help boost your credit score more than being approved for a credit card.
Which is Worse in Damaging Your Credit?
While installment and revolving credit can improve your score, they could also bring down your credit standing if you do not have a good grasp of both. Revolving credit can result in a hit in your credit score over time, but not maintaining payments on installment loans can also bring down your score significantly and stay with you for the long haul. Not only can unsecured loans associated with installment credit result in banks repossessing your assets, such as a car or house, a poor payment history can follow you for the long term. If you are unable to pay back your mortgage and this results in foreclosure, this negative event could lower your credit score by 250 to 280 points, according to credit bureau TransUnion, and remain on your credit report for seven years. In this case, bouncing back from late payments or defaults associated with revolving credit payments would be easier than with installment loans.
Both Are Necessary for Your Credit History
While there are both positives and negatives to installment and revolving credit, the bottom line is it's crucial to maintain a mix of both on your credit history. Ensure you are paying back what you owe on both types of credit on time to isolate any negative items on your report and to raise your overall score.