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Installment Loans Vs Revolving Loans. The Key Differences

- Dec 19, 2021 credit1 comment

There are two types of loans which a person can possibly have. The first 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 is crucial in order to build good credit.

In this post, I will share with you the differences between installment loans and revolving loans and how they may impact your credit score in different ways.

Regarding credit utilization

Carrying high balances 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 cash out money from a home refinance and repay the credit card balance, you still have the same amount of debt, however, since you transferred it from a revolving loan to an installment loan, your credit score will no longer be affected by this balance.

They have a different weight on your credit score

Installment loans usually are mortgages, car leases etc. that are backed with 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 than 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 always was on time on his mortgage.

Another reason 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. Therefore, credit models will give a better score for the revolving manager than for the installment manager.

Revolving loans may be harder to get approved for

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 of a risk when they approve a mortgage that is backed with collateral than when they approve you for a credit card that is not backed by any collateral (even if the mortgage is for $500k while the credit card is just $10k).

Make sure to have both

When building credit, it is very important to have both installment loans and revolving loans. Credit models will want you to prove yourself capable of handling different types of loans.

For an optimal credit score, I usually recommend having a minimum of three tradelines with a mix of two revolving loans (credit cards, etc)  and one installment loan (mortgage, auto loan, etc).

Frequently asked questions
If I buy a laptop with monthly installments, does that affect my credit?
Credit scoring models see these types of loans as a sign of someone who's overextending themselves. It's not a huge negative but it's a negative

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Sam Sam has nearly a decade's worth of experience educating his many readers on everything credit. Sam spends his days checking out credit cards for a full report, from the minute benefit details to the shebang of welcome bonuses. Plus studying the ins and outs of building proper credit. It’s his favorite pastime and he loves sharing it with others.

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1 Comment

  1. Hi i have very very bad credit, i dont even have a credit score, i want to build it up so i can be eligible for a big loan, can you help me with that? thank you

    Reply

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