There are two types of loans or debts which a person can possibly have. One type is an installment loan. (For example: mortgages, auto loans, or any loan that has a fixed amount that needs to be paid every month.) Another type is the revolving loan. (For example: credit cards or loans that don’t have a fixed amount that needs to be paid every month.)
Credit models treat these loans very differently when it comes to calculating your credit score. So, knowing the differences between these loans are crucial in order to build good credit.
In this post I will share with you the differences of installment loans and revolving loans and how they may impact your credit score in different ways.
Carrying high balances (above 15% of your credit line should be avoided) has a very big impact on your credit score. (For more on this read: credit utilization) But high credit utilization is a bad factor in regard to revolving credit only, and not by installment loans. Therefore, if your credit card has a high balance then your credit score will be affected strongly. But if you go ahead and take out a home equity loan and repay the credit card balance, you still have the same amount of debt. Since you transferred it from a revolving loan to an installment loan, though, your credit score will no longer be affected by this balance.
(You may also want to read: Paid My Balance! How Long Will It Take For My Credit Score To Go Back Up? )
Credit Score Weight
Installment loans usually are mortgages, car leases etc. that are backed with a collateral and not only a personal guarantee. Revolving credit will usually be a credit card etc. that is not backed with a collateral, therefore when credit models calculate a credit score, the revolving credit lines will carry a bigger weight in your credit score. At the end of the day, a person is more likely to pay his mortgage then his credit card bill, because if he doesn’t pay his mortgage he loses his house but when he doesn’t pay his credit card bill he does not lose anything (except his credit). Obviously, a person that never had a late on a credit card displays his trustworthiness more than when a person who always was on time on his mortgage.
The second factor why a revolving loan carries more weight in your credit score than an installment loan, is because a revolving loan changes the amount due month after month. That makes it harder to manage than an installment loan that has a fixed amount due every month. Understandably, properly managing a revolving loan for many years shows more responsibility than properly managing an installment loan for the same amount of years. Therefore, credit models will give a better score for the revolving manager than for the installment manager.
When building credit, it is very important to have both installment loans and revolving loans, because credit models will want you to prove yourself capable of handling different type of loans. The recommended number for a proper credit mix is: three revolving loans and two installment loans. (For more on this read: The 5 Most Important Factors In A FICO Score)
Harder to Get Approved
For the reason explained above, (revolving credit is usually not backed by a collateral and is only backed by a personal guarantee) it may be harder to get approved for a revolving credit loan than to get approved for an installment loan. This will answer the question which many people ask me. How come I got approved for a mortgage, but I can’t get approved for a credit card? Yes, it may be harder to get approved for a credit card than for a mortgage! That is because the bank is, to some extent, taking less risk when they approve an installment loan that is backed with a collateral than when they approve you for a revolving loan that is not backed by any collateral. (To learn how to get approved for a first credit card read this.)
Wishing you lots of success!