Types of Credit and How They Affect Your Credit Score
Updated · Apr 06, 2022
Credit is a certain amount of money you borrow from a bank or a credit union and pay it back, usually with interest.
There are three main types of credit:
- Open accounts
Every one of them is suitable for different purposes. Below, we take a closer look at each type and explain how they affect your credit score.
But first, let's go over the terms and conditions of credit.
Terms and Conditions of Different Credit Types
All credits have a few key components by which you can differentiate them.
The first one is the credit limit. This is the maximum amount of money that a lender is willing to extend to you. It is based on your credit history and income.
Your credit limit will also affect your interest rate—the amount you pay on top of the principal sum as a fee for lending the money.
The open account is the only credit without interest. Additional charges apply only if you’re late with the payments.
There are two main types of credit payments: fixed and flexible. The former remain the same each month, while the latter can vary from month to month. Typically, installment credit requires fixed payments. The other two types are more flexible.
Next, the different types of credit vary according to their repayment term length. With installment credit, the duration of the loan and monthly fee are fixed.
With recurring and open accounts, they are flexible. This means borrowers can choose the monthly payment amount and frequency.
Last but not least comes collateral. This is something you offer as security in case you can't pay back the full amount. It can be anything from money to your house or car.
Some lenders may also require a personal guarantor who agrees to repay the loan if the borrower defaults.
Credits with collateral are called secured. Common examples are mortgages and car loans. Unsecured accounts are, for example, personal and student loans. Credit cards usually fall under that category, although there are secured cards as well.
Basically, all types of credit could have collateral.
What are the different types of credit?
Now that we know what are the main terms and conditions of credits, let’s examine each type in more detail.
Installment or Closed-End Credit
This form of credit is repaid in fixed intervals and payments over a set period of time. The credit limit and repayment term length are determined when you take out the loan.
Installment credit is usually used for cars, mortgages, and personal loans. Let’s discuss some of these types in more detail.
Personal loans are among the most popular types of credit. The terms and conditions of personal loans vary, but they are usually unsecured.
This means you don’t have to pay collateral but the interest is higher. You can use them for a variety of purposes, such as house repairs or debt consolidation.
Mortgages are a type of secured loan which uses your property as collateral.
The terms and conditions of mortgages can vary. That said, they usually involve a fixed interest rate and monthly installments, and a predetermined repayment period.
Borrowers usually use them to buy a house or get a larger sum of money with lower interest.
Revolving or Open-End Credit
With this type of credit, also known as recurring, you can borrow money repeatedly up to a limit set by the lender.
The payments are flexible. Ideally, you can repay your balance in full each month. Alternatively, you can pay the minimum monthly amount due and pay off the rest over time.
Let’s see some common examples of revolving credit.
A credit card is the most common type of recurring credit. It allows you to borrow up to a certain amount of money. You can either withdraw cash or shop directly with the card.
The lender determines the limit based on your credit score and income. The types of credit cards are numerous—rewards, balance transfer, purchase, secured, travel, etc.
Each has slightly different terms and conditions, such as an annual percentage rate (APR), a grace period, and a minimum payment. But the core idea is the same.
Home Equity Line of Credit (HELOC)
Besides credit cards, the other most common form of open-end credit is the home equity line of credit (HELOC).
As the name suggests, it allows you to borrow money using your home equity as collateral. Unlike the home equity loan, it doesn’t provide the whole sum upfront. Instead, you can get credit as needed up to the limit.
Just like with credit cards, you have flexible monthly payments. Since it is secured, it has lower interest than other loan types.
That said, both the amount due and the interest rate vary according to the sum you’ve borrowed.
Personal Line of Credit
This is a revolving line of credit, which means the borrower can draw on it as needed and repay the amount over time.
The interest rate is typically lower than on a credit card and higher than fixed-term and secured credit.
A personal line of credit is a great option for financing large projects, such as home improvement. You can also use it to cover unexpected expenses, like moving to another country.
No, that’s not the same as open-end or revolving credit.
Open credit is a type of credit account with a set limit on how much the user can borrow. It is usually tied to a specific service, like electricity or water.
You have to pay the full amount each month. That said, the monthly payments may vary depending on your usage.
How Different Types of Credit Affects Your Credit Score
Your credit score is a number that indicates your creditworthiness. It is based on your credit history and affects your ability to get a loan or, in some cases, even a job or an apartment.
Financial institutions use five main factors to calculate it:
- Payment history
- Amounts owed
- Length of credit history
- Credit mix
- New credit
Different credit scores give different weight to each factor. Still, the main idea is the same.
This plays a relatively small role in calculating your score. Still, having various accounts demonstrates you can manage different types of credit.
So, try to diversify your credit history.
That said, even the perfect mix won't fix your score if you have a bad payment history or a large amount of debt.
Cach type of credit affects your history. So, you need to handle them responsibly.
With installment accounts, all you have to do is make the full payments on time. The same goes for open credit—pay your bills every month, and you'll build a positive payment history.
Managing recurring credit is tricky, though. Even if you pay off everything you borrow each month, it can still hurt your credit score.
That's why you need to monitor your credit utilization rate too.
Credit Utilization Rate
This is the percentage of your available credit that you are using.
For example, if you have a credit card with a $1,000 limit and a balance of $500, your credit utilization is 50%.
A high credit utilization ratio suggests you are struggling financially and might make lenders hesitant to lend to you. So, you should try to keep your rate below 30%.
There are a few ways to do that:
- Spread out your spending. You don't want to max out your cards in a short period of time.
- Pay off your balance in full before you borrow more money.
- Get two credit cards and distribute your spending between them.
Follow these tips, and you’ll maintain a positive credit history.
There are three types of credit: revolving, installment, and open. They differ by their limit, interest, repayment method, term length, and whether they have collateral or not.
Each one affects your credit score. To improve it, you need a good mix of revolving and installment loans. Managing several types of credit shows you can handle debt responsibly.
But more importantly, make sure you choose the right credit for your needs and pay it off on time.
With an eye for research, Aleksandra is determined to always get to the bottom of things. If there’s a glitch in the system, she’ll find it and make sure you know about it.