The 3 types of credit and why you might want them all
When consumers talk about credit, the first thing that comes to mind is credit cards. After all, about 70% of American households have at least one credit card, and most of us are used to using credit cards to pay for some of our expenses. Americans use credit cards to pay for everything from groceries to tropical cruises. Also, having a strong credit history and credit rating has become a necessity in today’s world.
However, «credit» and «credit card» are not interchangeable terms. Even if you don’t think your obligation is credit, you may already be using several different types of credit.
Mortgages, car payments, and even utility bills are all forms of credit, and we’ll explain how they’re classified. And how these three types of credit affect your credit score. It also explains why your credit mix is important to your credit score.
Even if you can’t set up installment credit up front, it’s likely that you’re currently paying for something on an installment credit plan or have an installment loan in the future.
The ladder credit works like this:
– You borrow a fixed amount of financing from a lender.
– You accept a fixed monthly fee (or installment) that you will make to pay off the debt within a certain period.
– If you pay in installments every month during this period, you have paid off the loan in full at the end of the term.
The monthly payment will include a fixed interest rate that you pay to the lender (remember: this is how they make money). In the case of an auto loan (which is one of the most common types of installment loan plans), you may find yourself in a situation where you agree to:
– Borrow funds to buy a $25,000 car.
– Pay a monthly fee of $475 to the lender.
– Pay these installments for each of the 60 months, in order to repay the loan in full within a period of five years.
Some quick math will tell you $475 x 60 months = $28,500. The additional $3,500 you pay over the life of the loan represents the lender’s interest. Some borrowers are eager to pay off their installment credit plans early, which may seem like a good idea at first glance, especially when shorter terms mean less interest. However, in this case, we are reminded of the importance of the «fine print» in any credit agreement. Some lenders charge penalties for paying installment credit plans before the end of the term.
These penalties and resulting fees can offset your interest savings. Be sure to check your specific installment credit plan before making a prepayment.
When dining with a group of friends and feeling very generous, few people say to themselves, «I’ll pay the bill, and I’ll pay it with my revolving credit.» I will use this type of package.
More commonly associated with credit cards, revolving credit plans are also used with personal lines of credit and home equity lines of credit. Today, credit card companies offer many different types of credit cards, from reward credit cards to student credit cards to business credit cards. While these different cards have different benefits and uses, they generally work like this:
– The borrower receives a maximum line of credit (the total amount of money that can be borrowed).
– When the borrower makes use of this credit, whatever the amount up to and including the maximum, the creditor determines a minimum payment due.
– The borrower could pay the amount owed in full, or the minimum monthly payments, or somewhere in between.
– If the borrower carries over a balance to the next minimum monthly payment, he will pay accrued interest and fees.
Revolving lines of credit can be the most difficult for people to manage, and the temptation to spend more than they earn has led many people into credit card debt.
Once a creditor offers a limit of $5,000, a revolving line of credit could fool someone into thinking they have $800 left to spend. The key to a revolving credit plan is to pay off your balance in full each month as much as possible.
For credit card users, it’s also important to remember that a $50 shirt can easily become a $100 shirt if you deposit it on a credit card that you don’t have the full balance on. The high interest rates associated with credit cards are devastating when you stick to a budget and live within your means. It’s important to research the lowest card rates before signing up.
This is where we clear up another common point of confusion for borrowers: a «charge card» is not the same as a credit card. A debit card is open credit where the borrower agrees to make a single payment and must pay the fee in full to avoid penalties or charge-offs. Payment cards don’t always have fixed limits, so, for example, if you have a good credit score, you could load the card $10,000 for a watch. But you also have to pay in full when next month’s bill is due, so you should have enough money to pay for your new luxury watch.
Public services also operate on an open credit system. Just like you can use a payment card to buy goods that are paid for in full when your bill is due, the utility company provides you with a service (in advance) that you can pay for in full when your bill is due.
Credit Composition and Credit Ratings
Credit composition is a factor in your credit score because it shows lenders that you can successfully manage various financial obligations. For example, simply having a credit card doesn’t give lenders an idea of your ability to handle your financial priorities.
The «mixed» credit category accounts for 10% of your credit score. Factors like payment history carry more weight and make up 35% of your score, but that doesn’t mean you should ignore the credit split as a way to improve your score by managing different types of successful accounts. The most important thing to remember is that you should only manage the portfolio of accounts that you can actually afford. You can read all the fine print associated with any type of credit to avoid high fees and penalties, and stick to a personal budget so you can pay your bills on time every time.