Select’s editorial team works independently to review financial products and write articles that our readers will find useful. We may receive a commission when you click on product links from our affiliate partners.
Having a combination of credit products in your name, such as a few credit card accounts and a mortgage or car loan, helps strengthen your overall credit profile.
These credit products fall into two broad categories: revolving credit and installment credit. Lenders like to see that you have both because it shows them that you can handle the many different obligations that come with borrowing all kinds of debt.
While these two types of credit are different, one is better than the other when it comes to improving your credit score. No matter the amount of balance, the interest rate, or even the credit limit, revolving credit is a lot more like how you manage your money than an installment loan.
Below, CNBC Select spoke with a credit score expert to understand the difference.
Revolving credit or installment credit: which one should you have?
To maintain a good credit rating, it is important to have both installment loans and revolving credit, but revolving credit tends to be more important than the other.
Installment loans (student loans, mortgages, and auto loans) show that you can pay borrowed money back consistently over time. Meanwhile, credit cards (revolving debt) show that you can withdraw varying amounts of money each month and manage your personal cash flow to pay it off.
Lenders are much more interested in your revolving credit accounts, says Jim Droske, president of Illinois Credit Services. So even if you have a large car loan over $ 20,000, lenders take a closer look at your credit cards, even if you have a very small credit limit.
“Assuming both bonds are still paid off as agreed, a credit card with a $ 500 limit can have a bigger impact on your credit scores than a $ 20,000 car loan,” Droske told CNBC. Select.
It’s important to pay both bills on time each month, as on-time payments represent 35% of your credit score. But only credit cards show whether you’ll be a reliable customer in the long run, he explains. Because your balance is constantly fluctuating, credit cards show how well you plan ahead and prepare for variable expenses.
“Credit scores predict future behavior, so scoring models look for clues to your good and bad history,” says Droske (who has a perfect credit score).
With a credit card, your balance could be less than $ 1,000 in one month, then three times that the next month. If your track record shows that you manage your money consistently enough to cover variable costs, lenders know that you are likely reliable enough to borrow more money in the future.
Why a $ 500 credit limit has a bigger impact on your credit score
Having both a car loan and a credit card in your name will impact your credit score, but the revolving credit account (your credit card) will play a bigger role in calculating your credit score. pointing. Here’s why:
- Reason 1: Revolving credit has a big influence on your calculation of your credit utilization rate, or the percentage of your total credit that you use. Your credit usage is the second most important factor (after payment history) that makes up your credit score. As you pay off your revolving balance on your credit card, your credit score will increase and you will free up more of your available credit. Whereas with an installment loan, the amount you owe each month on the loan is the same and the total balance is not calculated in your credit usage.
- Reason 2: Revolving credit has more of an impact on your credit score because it also offers more “financial clues” to your behavior than installment credit, says Droske. With a $ 20,000 auto loan, the borrower can only behave in several ways: either they make the monthly payment on time over the life of the loan, or they don’t. On the other hand, borrowers can make many decisions when using a credit card: charge a little and pay the minimum, maximize and pay off fully, not use it at all. The way you manage your variable debt says a lot to lenders about how you will manage future debt that you don’t already have.
If you don’t have one either, start with a credit card
If you don’t have a credit account in your name and want to build your credit history, it’s best to start with a credit card designed for newcomers.
CNBC Select has ranked the best credit cards for building credit, and the Visa® Petal® 2 “Cash Back, No Fees” credit card tops the list of best starter credit cards for several reasons.
First, the Petal 2 Visa credit card allows applicants with no credit history to apply, and there is no charge *. If you have a credit report, it is part of the credit decision. It also has a rewards program to help you build good credit habits: 1% cash back on qualifying purchases immediately, which can increase up to 1.5% after making 12 monthly payments. on time. This is a great benefit that can help you make monthly bill payments on time. Additionally, Petal offers 2% to 10% cash back at select merchants.
Another card to consider is the Capital One® Secured, which has a low security deposit (learn how secured credit cards work) and the Capital One® Platinum Credit Card, which is good for applicants with average credit.
Ultimately, the most important factor is that you are using your credit products to your advantage. Feel free to charge expenses to your credit card to earn points or cash back; just make sure you can pay the balance in full by the time the invoice arrives. The same goes for installment loans like personal loans, auto loans, and mortgages.
“In the long term, always pay off your installment loans,” Droske says.
Don’t miss: Revolving credit debt falls to $ 996 billion, lowest since the Great Recession
The Capital One® Secured and Capital One® Platinum credit card information was independently collected by CNBC and was not reviewed or provided by the card issuer prior to posting.
Petal 2 Visa credit card issued by WebBank, FDIC member.
* The regular APR variable for the Visa® Petal® 2 “Cash Back, No Fees” credit card currently ranges from 12.99% to 26.99%
Editorial note: Any opinions, analysis, criticism or recommendations expressed in this article are the sole responsibility of the editorial staff of Select and have not been reviewed, endorsed or otherwise approved by any third party.