Experian, one of the top 3 credit bureaus, lists payment history and credit utilisation as the two major factors that make up your credit score. However, they also put emphasis on some factors beyond these parameters that can adversely impact your credit score. One such factor, according to them, is credit mix or different types of credit accounts. Experian quotes the credit mix accounts for 10% of your FICO score.
So, if you’re someone who’s new to credit building in the US, it becomes important for you to understand what the different types of credit are and what implications they can have on your credit score.
What are the different types of credit?
For building your credit score in the US, all credit bureaus look at mainly three types of credit:
1. Revolving Credit
2. Installment Credit
3. Open Credit
You know this. Most of us use this on a daily basis. It’s one of the most common types of credit accounts. Remember credit cards? Revolving credit is the line of credit or the class of credit to which all credit cards belong to. It’s an open-ended credit account that can be used and paid down repeatedly as long as your account remains open. Home equity line of credit (HELOC) is another example of this type of credit.
In this type, the lender sets your pre-approved credit limit based on your ability to pay. This limit is the maximum amount that you can charge to that account. So, everytime you make a purchase, your credit limit goes down. And, everytime you make a payment, it shoots back.
This kind of credit is also one of the most common among people who seek to build their credit score. Installment credit refers to a loan on which you make fixed payments over a set time-period. It’s the whole spectrum of loans: mortgages, personal loans, student loans, auto loans, and more. Like revolving credit, installment credit aids you in building a long credit history.
In this line of credit, you borrow a certain amount from a lender to fulfill your goals of buying a car/house or paying for your kid’s education, and then make timely payments of a fixed amount until the entire loan amount is over.
Open credit is a much rarer form of credit. It is more on the same lines as revolving credit, but not exactly.
It’s a pre-approved loan agreement between a lender and a borrower. An open credit line allows the borrower to make withdrawals upto a specific limit and then make repayments prior to the due date. Sounds the same as a credit card?
Note: The only difference is that, in an open credit line, the borrower is obligated to make full payment on or before the due date. Whereas, with credit cards, the borrower can make part payments or minimum amount due payments. Charge cards are a type of open credit line.
How do different kinds of credit affect your Credit Score?
According to the bureaus, credit mix accounts for 10% of your credit score. Now, this number may seem like a negligible percentage, but if you think about it, it is the foundation of building your credit score.
For example, let’s say, out of the three kinds of credit, you only take instalment credit. Of course, your credit score will get built, but after a point it won’t see any improvement. Why? Because, under instalment credit, you get all the desired credit amount at once. So, there’s no “credit utilization” factor (which makes up 30% of your credit score) that the bureaus can consider while calculating your credit score. Credit utilization is something you get only with revolving and open credit.
So, if you've never had a credit card, it's worth having one so that you can use “credit utilzation” provided by credit card to build a solid credit history. Same goes for other credit types also. Different credit types bring a different value addition to your credit score.
The Bottom Line:
Having a credit portfolio with a mix of different types of credit - and paying them off timely, without carrying forward the balance - is an indication of how well you have & can manage a wide range of credit products. This will help lenders have more trust and confidence in you with more credit to fulfill your bigger goals. Lenders will see you as a low credit-risk individual due to your ability to meticulously manage different credit accounts at the same time.