Credit is the ability to borrow money or access goods or services with the agreement to pay later. Types of credit include revolving credit (credit cards), installment credit (loans), open credit (utilities), and service credit (contracts).
What is credit?
Credit is the ability to borrow money or access goods and services with the understanding that you’ll pay for them later. It involves a contractual agreement where the borrower receives something of value now and agrees to repay the lender at a future date, often with interest. Credit can be extended by banks, financial institutions, retailers, and service providers, and it plays a crucial role in personal finance, business operations, and the economy.
What are the three types of credit?
Credit is an essential component of personal finance, and understanding the different types of credit is crucial for managing financial health. The three primary types of credit are revolving credit, installment credit, and open credit. Each type has its own characteristics, benefits, and uses. Here’s a detailed explanation of each type:
1. Revolving Credit
Revolving credit is a flexible form of credit that allows consumers to borrow up to a certain limit, repay it, and borrow again as needed. The most common example of revolving credit is a credit card.
Characteristics:
- Credit Limit: Users have a set credit limit which they cannot exceed.
- Minimum Payments: Borrowers must make at least the minimum payment each month, though they can choose to pay more.
- Interest: Interest is charged on the outstanding balance if not paid in full by the due date.
- Revolving Nature: As the borrower repays the balance, the available credit replenishes, allowing for continuous borrowing.
Benefits:
- Flexibility: Borrowers can use revolving credit as needed, making it ideal for managing cash flow and unexpected expenses.
- Rewards and Benefits: Many credit cards offer rewards, such as cash back, travel points, and other perks.
- Building Credit: Responsible use of revolving credit can help improve credit scores.
Examples:
- Credit Cards: Allow for purchases up to a set limit, with the option to pay the balance over time.
- Lines of Credit: Similar to credit cards but often used for larger expenses or specific purposes, such as home equity lines of credit (HELOCs).
2. Installment Credit
Installment credit involves borrowing a fixed amount of money and repaying it in equal installments over a set period. This type of credit is typically used for large purchases that require a longer time to repay.
Characteristics:
- Fixed Amount: Borrowers receive a lump sum up front.
- Regular Payments: Repayment is made in regular, equal installments over a specified period.
- Interest: Interest rates are usually fixed, making monthly payments predictable.
- Term Length: The length of the repayment period can vary, depending on the loan type and amount.
Benefits:
- Predictability: Fixed payments make budgeting easier.
- Lower Interest Rates: Installment credit often comes with lower interest rates compared to revolving credit.
- Variety of Uses: Can be used for significant expenses, such as buying a home or car, or consolidating debt.
Examples:
- Mortgages: Loans used to purchase homes, typically repaid over 15 to 30 years.
- Auto Loans: Loans used to buy vehicles, usually repaid over 3 to 7 years.
- Personal Loans: Unsecured loans for various purposes, such as home improvements or medical expenses, with terms typically ranging from 2 to 7 years.
3. Open Credit
Open credit, also known as service credit, refers to credit arrangements where the balance must be paid in full each billing period. This type of credit is often used for ongoing services where usage can vary month to month.
Characteristics:
- Monthly Billing: Borrowers receive a bill for services used during the billing period.
- Full Payment Required: The full balance is due by a specified date each month.
- Variable Amounts: The amount due can vary based on usage or consumption.
Benefits:
- Access to Essential Services: Allows consumers to use services and pay for them later.
- No Interest: Typically, no interest is charged if the balance is paid in full each month.
Examples:
- Utility Bills: Monthly bills for services such as electricity, water, and gas.
- Cell Phone Bills: Monthly charges for mobile phone service.
- Gym Memberships: Monthly fees for access to gym facilities and services.
Understanding the three primary types of credit—revolving credit, installment credit, and open credit—is essential for managing personal finances effectively. Each type serves different needs and purposes, and knowing how to use them responsibly can help you maintain a healthy credit profile, improve your credit score, and achieve your financial goals.
How each type of credit affects your credit score
Each type of credit—revolving credit, installment credit, and open credit—affects your credit score in different ways. Here’s a detailed look at how each type impacts your credit score:
1. Revolving Credit
Revolving credit typically includes credit cards and lines of credit. Its impact on your credit score is influenced by several factors:
Credit Utilization Ratio:
- The credit utilization ratio is the amount of credit you’re using compared to your credit limit.
- A lower utilization ratio (preferably below 30%) is favorable and positively affects your credit score.
- High utilization can significantly lower your credit score.
Payment History:
- Timely payments positively affect your score.
- Late or missed payments can have a substantial negative impact.
Credit History Length:
- The longer you maintain revolving credit accounts in good standing, the better for your credit score.
- Closing old credit card accounts can shorten your credit history and negatively affect your score.
Credit Mix:
- Having a mix of revolving credit and other credit types can positively influence your score.
2. Installment Credit
Installment credit includes loans such as mortgages, auto loans, and personal loans. Here’s how it affects your credit score:
Payment History:
- Consistent, on-time payments on installment loans build a positive payment history, which is the most significant factor in your credit score.
- Late or missed payments can damage your score.
Credit Mix:
- Having installment loans along with revolving credit can enhance your credit mix, which positively affects your score.
Debt-to-Income Ratio:
- While not directly affecting your credit score, a high amount of installment debt relative to your income can impact your ability to secure additional credit and could be a factor considered by lenders.
Credit History Length:
- The duration of your installment loan accounts contributes positively to your credit history length.
3. Open Credit
Open credit includes accounts like utility bills, cell phone contracts, and other service-based credit. Its impact on your credit score is generally less direct but still significant:
Payment History:
- Regular, on-time payments of open credit accounts can positively impact your credit score.
- Late payments, especially those reported to credit bureaus, can negatively affect your score.
Credit Utilization:
- Unlike revolving credit, open credit does not have a credit limit and thus does not affect your credit utilization ratio.
- However, consistently high balances or unpaid bills can lead to collections, which severely impact your credit score.
General Impact Factors
Credit Mix:
- A diverse mix of credit types (revolving, installment, and open credit) is favorable for your credit score as it demonstrates your ability to manage various types of credit responsibly.
New Credit Inquiries:
- Applying for new credit results in hard inquiries, which can slightly lower your credit score temporarily.
- Multiple inquiries in a short period can have a more significant impact.
Length of Credit History:
- The age of your oldest account, the average age of all your accounts, and the age of individual accounts all play roles in determining your credit score.
- Maintaining long-standing accounts in good standing is beneficial.
Each type of credit—revolving, installment, and open—affects your credit score in unique ways. Managing these types responsibly by maintaining low balances, making timely payments, and diversifying your credit mix can help you build and maintain a strong credit score. Understanding these impacts allows you to make informed decisions about using credit and achieving your financial goals.
How to check your credit score (for free)
Checking your credit score regularly is important for maintaining good financial health. Here are several ways to check your credit score for free:
1. Credit Card Issuers
Many credit card companies offer free credit scores as a benefit to their cardholders. Some popular issuers providing this service include:
- Discover: Offers a free FICO score to all cardholders through the Discover Credit Scorecard.
- Capital One: Provides a free VantageScore through the CreditWise tool, available to everyone, not just Capital One customers.
- Chase: Offers a free credit score through the Credit Journey tool.
2. Credit Bureaus
You can access your credit reports for free from each of the three major credit bureaus once per year through AnnualCreditReport.com. While these reports do not include your credit score, you can often purchase the score for a nominal fee. However, due to the COVID-19 pandemic, the three major bureaus are offering free weekly online reports through AnnualCreditReport.com until April 2022.
- Experian: Offers a free credit score directly from their website.
- Equifax: Provides free credit reports but charges for the score.
- TransUnion: Offers various paid products that include credit scores.
3. Personal Finance Websites
Several websites offer free access to your credit score along with other financial tools:
- Credit Karma: Provides free access to your TransUnion and Equifax VantageScore, updated weekly.
- Credit Sesame: Offers a free TransUnion VantageScore and monthly updates.
- WalletHub: Provides free daily updates to your TransUnion VantageScore.
4. Financial Institutions
Some banks and credit unions offer free credit scores to their customers. Check with your financial institution to see if this service is available.
5. Non-Profit Credit Counselors
Non-profit credit counseling agencies may provide free access to your credit score as part of their financial education services.
6. Mobile Apps
Some mobile apps provide free credit scores and credit monitoring services:
- Mint: Offers a free credit score through its app, updated every three months.
- NerdWallet: Provides free credit scores and credit report information.
Steps to Check Your Credit Score for Free
- Choose a Source: Decide which method or service you prefer to use from the options above.
- Sign Up or Log In: If using a website or mobile app, you will need to create an account or log in if you already have one.
- Verify Your Identity: You may be required to provide personal information such as your Social Security number and date of birth to verify your identity.
- Access Your Score: Once your identity is verified, you can view your credit score. Some services also provide additional information, such as credit reports, credit monitoring, and tips for improving your score.
Tips for Using Free Credit Score Services
- Understand the Score Type: Be aware of which type of credit score you are viewing (FICO or VantageScore) and from which bureau it is sourced.
- Monitor Regularly: Regular monitoring helps you spot errors or signs of identity theft early.
- Use Multiple Sources: Check your score from different sources to get a comprehensive view of your credit health.
- Read the Fine Print: Some free services may try to upsell additional paid features. Be cautious and only sign up for what you need.
By utilizing these free resources, you can stay informed about your credit health and take proactive steps to manage and improve your credit score.
What types of credit should you have?
Having a diverse mix of credit types can positively impact your credit score and demonstrate to lenders that you can manage various kinds of credit responsibly. Here are the main types of credit you should consider:
1. Revolving Credit
Revolving credit involves credit lines where you can borrow up to a certain limit, repay it, and borrow again. Examples include:
- Credit Cards: These are the most common form of revolving credit. They offer flexibility for everyday purchases and can help build your credit score if used responsibly.
- Lines of Credit: Similar to credit cards, lines of credit (such as a home equity line of credit or HELOC) provide access to funds up to a specified limit, which can be drawn upon as needed.
Why It’s Important:
- Credit Utilization: Helps build your credit utilization ratio, which is a significant factor in your credit score.
- Flexibility: Provides flexibility for managing cash flow and unexpected expenses.
2. Installment Credit
Installment credit involves borrowing a fixed amount and repaying it in regular, scheduled payments over a set period. Examples include:
- Mortgages: Loans for purchasing a home. These are typically long-term loans with fixed or variable interest rates.
- Auto Loans: Loans for purchasing vehicles. They usually have fixed interest rates and terms ranging from 3 to 7 years.
- Personal Loans: Unsecured loans for various purposes such as debt consolidation, home improvement, or medical expenses.
- Student Loans: Loans specifically for funding education. They often have flexible repayment options based on income.
Why It’s Important:
- Credit Mix: Having installment loans contributes to a better credit mix, which is beneficial for your credit score.
- Payment History: Regular, on-time payments on installment loans positively impact your payment history, the most critical factor in your credit score.
3. Open Credit
Open credit, also known as service credit, involves accounts where the balance must be paid in full each billing period. Examples include:
- Utility Accounts: Monthly bills for services like electricity, water, and gas.
- Cell Phone Bills: Monthly charges for mobile phone services.
- Charge Cards: Similar to credit cards but require the balance to be paid in full each month (e.g., American Express charge cards).
Why It’s Important:
- Essential Services: Allows access to necessary services with deferred payment.
- Payment History: Timely payments on these accounts contribute positively to your credit score.
Benefits of a Diverse Credit Mix
- Improves Credit Score: A diverse mix of credit types shows that you can manage different forms of credit responsibly, which can boost your credit score.
- Demonstrates Creditworthiness: Lenders prefer borrowers who have a proven track record with various types of credit, as it indicates reliability and financial stability.
- Enhances Credit Profile: Having a combination of revolving, installment, and open credit accounts can create a more robust and appealing credit profile.
How to Manage Different Types of Credit
- Make Timely Payments: Ensure you pay all your credit accounts on time to maintain a positive payment history.
- Monitor Credit Utilization: Keep your credit card balances low relative to your credit limits to improve your credit utilization ratio.
- Avoid Unnecessary Debt: Only take on credit that you need and can afford to repay.
- Regularly Check Credit Reports: Review your credit reports from the three major credit bureaus (Experian, Equifax, and TransUnion) to ensure accuracy and identify any issues.
A healthy credit profile typically includes a mix of revolving credit (like credit cards), installment credit (such as auto loans and mortgages), and open credit (like utility accounts). Managing these different types of credit responsibly by making timely payments, maintaining low balances, and regularly monitoring your credit can help you build and maintain a strong credit score.
How to build credit
To build credit, consistently make on-time payments, keep credit card balances low, avoid opening too many new accounts at once, and maintain a mix of credit types. Regularly check your credit reports for accuracy and address any errors promptly. Responsible credit usage over time strengthens your credit profile. Click for details- How to Build Credit: Tips and Tricks for a Better Credit Score
What’s the best way to manage my growing credit card debt?
To manage growing credit card debt, create a budget to track expenses and cut unnecessary spending. Focus on paying off high-interest cards first using the avalanche method, or tackle smaller balances with the snowball method for quick wins.
Consider transferring balances to a card with lower interest rates or a personal loan. Always make at least the minimum payments on time to avoid fees and additional interest. Seek professional advice if needed, such as from a credit counseling service.
How do I go about building my credit history?
To build your credit history, start by applying for a secured credit card or becoming an authorized user on someone else’s card. Make small purchases and pay the balance in full each month to establish a positive payment history. Consider taking out a credit-builder loan from a bank or credit union.
Keep your credit utilization ratio below 30% by not maxing out your cards. Avoid opening too many new accounts at once. Regularly check your credit report for errors and dispute any inaccuracies. Responsible usage and timely payments over time will strengthen your credit history.
Will applying for multiple credit accounts hurt my score more than single application?
Yes, applying for multiple credit accounts in a short period can hurt your credit score more than a single application. Each application results in a hard inquiry on your credit report, which can temporarily lower your score.
Multiple inquiries within a short time frame can signal to lenders that you are seeking to take on a lot of debt, which may be seen as a risk. It’s better to space out credit applications and only apply for new credit when necessary. Responsible management of a few accounts over time will help improve your credit score more effectively.
What are inquiries and how do they affect my score?
Inquiries are requests to view your credit report. There are two types: hard inquiries and soft inquiries.
Hard Inquiries
- What They Are: Occur when a lender or creditor checks your credit for a loan or credit card application.
- Impact on Score: Can lower your credit score slightly and remain on your report for up to two years.
- Effect: Multiple hard inquiries in a short period can signal financial distress and negatively affect your score.
Soft Inquiries
- What They Are: Occur when you check your own credit, or when an employer or lender pre-approves you for an offer.
- Impact on Score: Do not affect your credit score.
- Effect: Only visible to you and do not indicate risk to lenders.
Overall Impact
Hard inquiries are more significant for your credit score than soft inquiries. Limiting the number of hard inquiries can help maintain a healthier credit score.
