Receiving a new credit card is exciting. The possibilities of what you can do with it likely jump around in your head. But, before you start using that card, you should know how it affects you. Not using your credit card responsibly could seriously harm your credit score.
Did you know that even a small credit card limit can affect your credit more than your jumbo mortgage? It’s true. Revolving credit has a serious impact on your credit score. Installment credit, on the other hand, doesn’t have the same impact if used responsibly.
You may wonder what the difference is between the two. It’s the collateral. Installment loans usually have something tied to them, such as a house or car. Revolving debt, however, has no collateral. It also has the opportunity to over-used. This is a big credit risk. If you default, there is nothing for the bank to take. They stand to take a big loss.
Understanding Revolving Credit
Another word for revolving credit is a credit card. You know the drill. You apply for a credit card and the company provides you with a “limit.” The rest is up to you. The credit limit can sit there untouched for years or you can use it as much as you want. Technically, you can use the entire amount. Your credit score begs to differ, though. We discuss how credit cards harm your credit below.
Understanding Installment Credit
Installment credit is a loan. It can be a car loan, mortgage, or personal loan. You receive a set amount that pays for a specific item, such as a car or home. You pay monthly payments over the life of the loan. The payments may differ if you have an adjustable rate loan. However, you always make a specified payment. This payment covers the principal and interest on the loan. Installment loans are easier on your credit score. We discuss how below.
How Revolving Credit Hurts Your Score
Credit cards are unique. You can use them over and over again. Because of this, your credit utilization ratio affects your score in a big way. This means the amount of credit you have outstanding compared to your available balance. This poses a problem for many people who are unaware. Aren’t you given a credit balance to use? In theory, yes, but you must use it responsibly.
What does responsibly mean? In terms of your utilization rate, it means using no more than 30% of your available balance at one time. On a $1,000 credit limit, this means $300. Pretty eye-opening, isn’t it? The good news is, your credit score takes into consideration your total available credit and total debts. If you have more than one credit card, it works to your advantage. Unless, of course, you have high balances on every card.
For example, let’s say you have three credit cards each with $1,000 available credit and the balances are as follows:
Your total outstanding debt equals $1400. This is 46% of your available credit. This harms your credit score. In order to reduce the harm your outstanding debts do to your score, you can do one of two things:
- Pay the balances down so they are no higher than $900 (30% of $3,000)
- Open new credit but don’t use it. This helps to increase your available credit without increasing your debt load.
Of course, opening a new credit card has its implications. It could lower your credit score, but not as much as a high utilization rate will hurt your score.
The Installment Loan Difference
Installment loans are also a debt. You might think they would hurt your credit score. However, they are a fixed amount of debt. You receive the total amount of the loan and you start paying it back right away. Your balance should decrease every month, assuming you make your payments. Because you cannot borrow the money again, it doesn’t affect your credit score as much as credit cards do.
Late Payments Hurt Your Score
Keep in mind, though, any late payment hurts your credit score. It doesn’t matter if it is a credit card or installment loan payment. A late payment is a late payment. If you make a required payment more than 30 days late, it affects your score. The credit scoring model records late payments in increments of 30 days. For example, if you don’t make a payment for two months, it will show up as a 60-day late rather than a 30-day late. This will affect your credit score even more than a 30-day late.
A Healthy Balance
You need a healthy balance between revolving and installment debt. Credit heavy with revolving debt and no installment debt, is a recipe for a bad score. If you have a good balance between the two, though, you pose less risk to a lender. That is not to say you should open credit to have it. What it means is you should watch your credit usage carefully. Be smart with the debt you take on, making sure you can afford it. Credit cards can be great, but not when they are used as long-term loans. Instead, they can serve as a secure way to make purchases that you can afford to pay in cash at the end of the month.
Revolving credit and installment credit both have their place in your life. But, knowing how to use them is crucial. Banks usually pay close attention to your ratios. They look at your debt ratio and how well you pay your bills. They usually try to avoid overextending any consumer for fear of default. But, no system is perfect. You must be in charge of your own financial life. Make smart choices and pay your debts down as you can. Never close unused credit accounts, though. They can help your utilization rate stay low. This is the key to a healthy credit score.