Whether you are a single person just starting life on your own, a couple looking to buy your first home, or a budding entrepreneur seeking to start a business, credit affects every aspect of your life. Credit affects your financial health and ability to get what you want, find a place to live, and much more.
Not learning about different kinds of credit and how to manage it can severely affect your life, leading to a poor credit history. Lenders will not trust you, making it difficult to live a comfortable life and, in some cases, even prevent getting the job you want.
Credit isn't a one-size-fits-all proposition. We'll go over the different credit types, how each works, and what you can do to get and maintain good credit.
Types of Credit: A Brief Overview
Generally, consumers will find three major types of credit: revolving, installment, and open. The type you apply for and hopefully receive approval for depends on your needs.
Definition of Credit
Credit is a contractual agreement in which you, the borrower, receive something of value, such as a car, a large appliance, or even money. You agree to repay the money over time, usually with interest.
Why It's Important to Understand Different Credit Types
According to Credit Karma, understanding the different credit types and how to use them shows financial institutions, credit card companies, and others that you can handle money responsibly.
Successfully managing different credit and the payment systems that go with them can help strengthen your credit score.
Here is an overview of the three main types of credit:
- Revolving: This type comes with a specific limit you can use until you reach that amount. You may have regular payments but no fixed repayment schedule.
- Installment: Fixed payment schedules at recurring intervals for specific lengths of time characterize installment loans.
- Open: This financial arrangement allows users to access credit up to a specified amount, but the funds must be repaid each month or at the end of the specified period.
Understanding the 3 Main Types of Credit
1. Revolving Credit
Revolving accounts have a set amount of funds available to consumers even as they pay their balances. The amount remaining available decreases as you use it but increases when you pay all or part of the balance.
If you have several revolving accounts in good standing, your status demonstrates that you are a good credit risk. Many lenders consider good revolving credit as pre-approval for other types of loans. Examples include:
- Credit cards
- Home equity lines of credit (HELOC)
- Personal credit lines
- Business loans
Advantages of Revolving Credit
- You aren't required to make a purchase when you open a revolving account, yet it remains available when you need it.
- Flexibility for emergency purchases
- Can help businesses through seasonal fluctuations
Disadvantages of Revolving Credit
- Interest charges can add significantly to the cost if you don't pay the balance in full
- Some accounts can have high-interest rates
- Credit card debt can accumulate quickly if you use multiple cards
- High credit utilization rates can hurt your score
How to Manage Revolving Credit
Using revolving accounts can become a risky way to borrow if you don't use your available funds wisely. Keep your credit utilization rate low, below 30%, if possible. Other tips include:
- Spend responsibly instead of giving in to whims
- Pay more than the minimum amount due
- Pay off high-interest accounts first
- Make all payments on time
- Monitor your credit regularly
2. Installment Credit
Installment credit involves borrowing a fixed sum of money with a set number of payments you agree to pay over time.
These loans can come with fixed or variable rates, meaning payments can increase or decrease with the latter type, especially if your agreement is tied to the prime interest rate. Examples of installment lines of credit are:
- Auto loans
- Home Mortgages
- School loans
- Personal loans
Advantages and Disadvantages of Installment Credit
Lenders typically tailor installment loans to meet the specific needs of borrowers. This feature often makes them a good choice for consumers and businesses. They are attractive because of their many advantages, including:
- Gives consumers the ability to make big purchases
- The payment amount usually stays fixed throughout the loan's duration
- Ability to save money on interest by paying off the loan early
Nevertheless, you may encounter disadvantages, such as:
- Some lines of credit may have high fees
- Consumers may be stuck with high-interest rates for some long-term loans
- Late or missed payments can damage credit
Managing Installment Lines
Taking out installment lines with long terms can be risky if your circumstances change during the loan.
If you cannot avoid a long term, try making more than the minimum payment as much as possible to pay down the principal.
3. Open Credit
When you have an open line, it essentially means you don't have a hard-set credit limit. Payments are usually due in full each month and can vary, as these usually depend on the usage of something involved in a contract or a service. Examples are:
- Electricity, gas, sewer, and water bills
- Charge cards with no preset limit
Advantages and Disadvantages
Open credit is readily available for many consumers, often not requiring consumers to reapply for funds when emergencies arise. Lower interest rates also make this alternative attractive.
Disadvantages include higher interest rates and unexpected maintenance fees. The lender may also suddenly decide to change terms, which many consumers may miss or not understand, ultimately resulting in higher costs.
How to Manage Open Lines of Credit
When it comes to open lines of funding, manage them as you would a revolving card account. Don't overextend your usage; pay as much as you can toward your monthly balance.
Other Types of Credit
Closed Credit
This term is confusing, as some financial entities use it to designate accounts that are no longer open, i.e., closed.
However, closed credit refers explicitly to instances where consumers apply for a specific amount of money, which they receive and repay in fixed payment. Closed credit examples:
- Home mortgages
- Auto loans
- Some personal lines of credit
Advantages and Disadvantages
With a closed credit account, you can't spend more than the amount initially lent. The most significant disadvantage is that you don't have the flexibility available with open accounts.
Tips for Managing Closed Credit
Closed credit also encompasses no longer active accounts, meaning you can't access funds. Manage these accounts by trying to remove them from the three major credit reporting bureaus.
Secured Credit
Secured credit is a type of credit account where collateral guarantees the amount given to borrowers by a lender.
These financial instruments are usually lump sum installment loans where the item you purchase with the credit serves as collateral. Secured credit examples are:
- Installment lines like mortgages and auto loans
- Pre-paid charge cards where borrowers must secure their purchases with a deposit
Advantages and Disadvantages
Secured credit can allow those with little or no credit history to build their credit reputation for lenders. Getting approval for a secured line can help you obtain funds that you otherwise be able to get with an unsecured line.
The primary disadvantage of secured credit is that you can lose your collateral if you default on the loan. The lender can repossess your vehicle or home if you fall behind on payments.
Tips to Manage Secured Credit
These tips pertain mainly to charge cards. Self Inc. recommends you do the following:
- Choose your secured card carefully
- Make sure the card reports to all three credit bureaus
- Make on-time payments
- Keep credit utilization low
- Monitor your credit activity and score
- Upgrade to a secured card when you have an established history
Unsecured Credit
This credit type refers to credit lines or loans not guaranteed by collateral.
These generally encompass many loans or revolving cards, but some financial experts say the latter should be in a separate category as all differ in offerings and structure. Examples of unsecured credit include:
- Most credit cards
- Personal loans
- Student loans
Advantages and Disadvantages
Are you seeking lower interest rates? If so, you'll love unsecured loans and credit lines. Other advantages you'll find are:
- No collateral required
- Less risky
- Easier to qualify if you don't have property
- Quicker application process
Disadvantages are significant:
- Interest rates are often higher
- Hard to qualify with low creditworthiness
- A lower amount of money available to borrow
Tips for Managing Unsecured Credit Lines
Managing unsecured funds typically follows that for credit cards. Rules to follow include:
- Don't use your entire credit limit
- Think wisely before purchasing items you may not need
- Repay credit card debt on time
Credit Scores and Reports
The number reported by the three agencies is your score, which is a significant component of creditworthiness and factors into your report from each agency.
These two elements combined can determine whether lenders will take a risk and provide you with a loan or deny you because they believe you won't repay your debt.
Why are Scores and Reports Important?
Lenders, whether they are credit card companies, financial institutions, or other entities, must have some basis to determine your creditworthiness.
Bad scores and reports can drag you down, while good scores can lift you.
Factors Affecting Your Score
The biggest factor affecting your score is how you pay your credit bills. Other important factors include your usage ratio and credit mix.
How Can I Check My Score and Report?
Checking both is quite simple as many banks and credit cards give you this information for free. Just go to freecreditreport.com to get a report from all three major U.S. credit bureaus.
Frequently Asked Questions about Credit
- What is the difference between revolving and installment credit? Revolving loans allow borrowers to use money as needed up to a set limit, repay it, and borrow again. Installments provide you the money in a lump sum, which you pay back in scheduled installments until fully paid.
- What is a secured credit card? A secured credit card requires you to deposit money to the card issuer before you can use it. The deposit acts as a safeguard if you miss any payments.
- How often should I check my score? Most experts recommend that you should check your reports to view your score at least once a year, although doing so every six months is better. Check all three services, Experian, Equifax, and TransUnion to determine if all information is correct.
- How can I improve my credit score? By paying all credit bills on time every month, keeping your credit balances low, and having a mix of credit types that show you can responsibly handle these funds, you can increase your score. Paying more than the minimum amount can also improve it.
- What happens if I miss a payment on my credit card? If you don't make the minimum payment on a credit card, it could affect your score. If the card issuer reports the missed payment, it could stay on your credit report for up to seven years.
Understanding Credit Can Improve Your Financial Health
Navigating the intricacies of the credit world is easier than most people think. Understanding how to manage different types of credit and determining what best fits your situation is essential to managing your finances.
121 Financial Credit Union can make your life easier by offering various credit options that fit your needs and budget. Contact your staff today to discover your options.