When it comes to revolving credit and installment credit, there’s a big difference. And here’s why that difference matters…
When diving into the distinction between revolving credit and installment loans, you must know the definition of each. Sure, it might not be the most interesting of topics, but in the “world of credit”, understanding these terms – or not – could have a definitive impact on your FICO® Scores.
According to Experian, one of the three major credit bureaus in the U.S., the definitions for revolving and installment credit are:
The term “revolving credit” or “revolving account” refers to an account on your credit report that has a credit limit set by the lender. You’re allowed to determine how much you will charge and how much you will pay off each month.
Examples of revolving accounts include credit cards and home equity lines of credit (HELOC).
An installment loan is a credit account where you borrow a fixed sum of money and agree to make monthly payments of a set dollar amount until the loan is paid off. An installment loan can have a repayment period of months or years.
Examples of installment loans (often seen on credit reports) include home mortgages and car loans.
Revolving Credit, Installment Credit and Your Credit Score
Since “Credit Mix” (different types of debt) accounts for 10% of your FICO® Score, having both revolving and installment credit can help your credit score. However, there’s not only a difference in the definition of these types of loans, there’s also a difference in how they can potentially affect your credit score.
As you probably already know, your timeliness and consistency when repaying any type of loan is the primary driver of your score. So first things first: no matter what type of loan you have, pay it on time, every time.
When it comes to deciding which to pay off first, installment or revolving credit, it’s often best to focus more heavily on the revolving credit. Credit Utilization makes up 30% of your credit score and measures the amount of your credit limit that’s being used. If the credit scoring model calculates this amount as being too high, your credit score could be negatively impacted.
Another reason revolving debt typically carries more weight than installment debt in determining your credit score is that revolving debt is usually unsecured. The lender assumes a greater degree of risk – if you don’t pay the debt, there isn’t any collateral for the lender to claim. On the other hand, installment debt is usually tied to some form of collateral, like a home or car, and losses can potentially be recouped.
4 Things to Keep an Eye On
When deciding which loan to pay down first and how much to pay, there are four things to focus on:
- Your Credit Score. As discussed, as you pay off revolving debt, you lower your credit utilization. A lower credit utilization often helps to increase your credit score.
- Credit Card Credit card companies are known for charging higher (much higher) interest rates than installment loans. That alone is one good reason to pay off your credit card loans first.
- Transfer Expiration Dates. For those debts you transferred to a 0% APR credit card, be sure to pay down the balance before that 0% expires and the rate rises.
- In many installment loan situations (primarily mortgages), you’re eligible for a tax benefit in the form of interest deductions. That’s not possible for credit card debt.
Check out the myFICO forums where all different kinds of loans and credit are discussed on a daily basis. Also, read more about how the amounts you owe and your credit utilization can affect your credit score.