A strong credit mix can help increase and strengthen your credit score. However, you might not know whether adding revolving credit or installment loans to this mix will be beneficial for you.
The majority of credit products fall under these two categories, so it is crucial to understand what they entail. Keep reading to learn more about the key differences between these two types of credit and which one is best suited for your needs.
What is an installment loan?
An installment loan, also known as installment credit or debt, is a type of loan you contribute fixed payments to over a specified period of time. This includes personal loans, student loans, auto loans, and mortgages.
These fixed payments usually are on a monthly basis and usually include an interest rate. Installment loans are a great way to build credit if you make your payments on time and in full.
What is revolving credit?
Unlike installment credit, revolving credit is an umbrella term for three main types of credit accounts. This includes credit card accounts, personal lines of credit, and home equity lines of credit (HELOC). Additionally, this category is one of the most impactful categories on your credit score. This is because credit bureaus take into consideration your credit utilization rate in addition to your payment behavior on these accounts.
How do these types of credit affect your credit score?
These are two of the most impactful credit categories on your credit report. Additionally, these types of credit are the most common way consumers use credit. Learn how each of these categories affects your score.
Installment loans
Installment loans can help your credit score in various ways. Adding on-time payments can improve your current credit score. Additionally, this adds to your credit mix which can also help your score.
However, when getting an installment loan does not guarantee there will be a positive or immediate impact on your credit score. It is important to have responsible account management and make on-time consistent payments. Without this, late or missed payments can result in a negative impact on your credit score.
Revolving credit
Similar to installment loans, revolving credit can help or hurt your credit score depending on your account management. It has the same benefits for your credit score through adding to your payment history and adding to your credit mix. However, revolving credit has a unique aspect to it that consumers need to look out for.
Credit utilization is a large component of revolving credit and is a key metric credit bureaus look at when calculating your credit score. Your credit utilization rate is the amount of revolving credit you used divided by the credit available.
It is important to keep your credit utilization rate under 30% because otherwise, it can hurt your credit score, which is an unattractive look in the eyes of lenders. If you can keep your credit utilization rate under 30% and practice perfect payment behavior, your credit score will drastically improve.
Pros and cons of installment loans
Even though installment loans seem like a steady way to improve your credit score, there are some factors to take into account. Find out what the perks and downsides are to taking out an installment loan.
Better interest rates
If a lender deems you as a qualified borrower due to your credit history, they can offer you better interest rates on the loan. However, if you do not have a great credit score, there are still loans you can apply for but they may have higher interest rates.
Whether a lender provides you with a favorable interest rate or an unfavorable one will be fully dependent on whether they believe you have a strong history of creditworthiness. But overall, these loans offer lower interest rates in comparison to other loan types.
Predictable payments
One of the biggest perks of installment loans is that the monthly payment amount is not a surprise. These payments are fixed and do not fluctuate over time. This allows you to prepare for the payment throughout the month and practice good financial management. However, if you’ve made a late payment, this amount may fluctuate.
Ability to fund big purchases
Installment loans are a great way to assist you in making a large purchase. This loan can help you put down a sizable amount of money towards a mortgage, car, or other expensive purchases. Due to this, an installment loan is a considerably good option for those who need this upfront capital.
High fees
Due to these low interest rates, and more leniency with credit score requirements, these installment loans are subjected to higher fees. This means that if a payment is missed or late, you may have to cough up a higher fee than you would on a usual loan. Additionally, this is due to the fact that installment loans do not require collateral, which is why these fees are larger.
Pros and cons of revolving credit
Revolving credit can substantially impact your credit score, both positively and negatively. Find out which characteristics of revolving credit affects your score.
Access to funds
With revolving credit, one is able to easily access funds. Depending on your credit limit, you will be able to utilize a certain amount of credit whenever you want. Which is beneficial if you need cash or funds quickly. However, it is vital that you pay off your balance by the end of the credit cycle. If you don’t do so, you risk negatively affecting your credit score.
Purchase protection
Several credit card companies offer purchase protection when opening an account. This protection acts as a type of insurance on any item you bought if it was recently stolen or damaged after a set period of time. Additionally, it allows you to replace this item or potentially be reimbursed for it.
Risk of blowing your budget
With credit cards it is easy to blow your budget. It is important to keep your credit utilization rate low for revolving credit since it could impact your credit score. Moreover, with this type of credit, one can easily spend over their means due to the availability of credit and funds.
If you do spend more than you can afford, you are at risk of decreasing your credit score and going into debt. This is especially true because most credit card companies have high interest rates and late penalty fees for overdue balances.
High interest rates
Since credit cards are viewed as an unsecured loan, meaning there is no collateral, lenders charge higher interest rates. Regardless of how good your credit score may be, credit cards are viewed as risky to banks since they are unsecured. By implementing high interest rates, lenders are able to encourage cardholders to pay their monthly balances on time.
Which debt should you pay down first?
Even though both of these credits have an impact on your credit score, it is advised to pay off your revolving credit debt first. This is because revolving credit has a substantial impact on your score due to the fact that it includes credit utilization and payment behavior. Additionally, revolving credit tends to have higher interest rates which can cause the debt to increase at a drastic rate. The average APR for revolving credit is 16.6% whereas the average installment credit rate is 2.75%.
Why diversifying your credit can help your score
Having a substantial amount of credit mix is beneficial for your credit score. When it comes to revolving credit and installment loans both are great ways to boost your credit when responsibly managed.
The key difference between these two types of credit is what products they offer, whether that be personal loans or credit card accounts. Overall, both of these credit categories have a considerable amount of impact on your credit score. As such, they should be handled wisely.
FAQ
What is the difference between installment and revolving credit?
Installment and revolving credit differ by the credit products they cover. Installment credit is considered personal loans, mortgages, and car loans whereas revolving credit covers credit cards and personal lines of credit.
What are revolving and installment loans?
Revolving credit and installment loans are umbrella terms for products of credit. Both of these categories have a substantial impact on your credit score.
What are the two basic types of credit?
Installment loans and revolving credit are two most commonly used types of credit.
