When consumers think of credit, the first thing that comes to mind is usually a credit card. After all, approximately 70% of American households have a least one credit card, and most of us are accustomed to using them to cover some portion of our expenses.
Americans charge everything from modest grocery trips to tropical cruises on credit cards. Plus, having a solid credit history and credit score has become a necessity in the world today.
However, “credit” and “credit card” are not interchangeable terms, and there are several different types of credit you may be using already, even if you do not think of these obligations as credit.
Your mortgage payment, car payment, and even your utilities are all forms of credit, and we will explain how they are categorized. We will also look at how the three types of credit play into your credit score and why the mix of credit is important for that score.
Even if you cannot define installment credit offhand, chances are you are currently paying for something in an installment credit plan or you will have an installment loan in the future.
Installment credit works like this:
– You borrow a set amount of funding from a lender.
– You agree to a fixed monthly installment (or payment) that you will make in order to pay off the debt in a specific timeframe.
– If you make the installment payment every month during that time frame, you have paid off the loan in full at the end of the term.
The monthly installment will include a set interest rate you are paying the lender (remember: this is how they make money). In the case of a car loan (which is one of the most common types of installment credit plans), you may be in a scenario where you agree to:
– Borrow funds to purchase a $25,000 car.
– Pay a monthly installment of $475 to the lender.
– Pay those installments for each of 60 months, in order to pay for the loan in full in a five-year term.
Some quick math will tell you that $475 x 60 months = $28,500. The extra $3,500 you pay over the term of the loan is the interest for the lender.
Some borrowers are eager to pay off installment credit plans early, which on the face of it seems like a wise thing to do, especially when a shorter timeframe means less interest.
However, this is one scenario where we are reminded how important the “fine print” is when it comes to any credit agreement. Some lenders have penalties for paying an installment credit plan off before the end of the term.
Those penalties, and the resulting fees, could cancel out the interest payments you saved. Be sure you double-check your specific installment credit plan before paying early.
When dining with a group of friends and feeling particularly generous, few individuals say “I’ll take the bill and cover it with my revolving credit.” But that is indeed the type of plan you are using if you decide to pay for the group’s meal on a credit card.
Revolving credit plans are most often associated with credit cards, and they are also used with personal lines of credit and home equity lines of credit. There are many different kinds of credit cards offered by credit card companies today, from a rewards credit card to a student credit card, to a business credit card. While these different cards hold different perks and use they generally work like this:
– The borrower is given a maximum credit line (the total amount of money she can borrow).
– When the borrower utilizes that credit, in any amount up to and including the maximum, the creditor determines a minimum payment owed.
– The borrower could pay the amount owed in full, or the minimum monthly payments, or a number in between.
– If the borrower carries a balance to the next minimum monthly payment, she will pay accrued interest and fees.
Revolving credit lines can be the most difficult for individuals to manage, with the temptation to outspend what you earn leading many into credit card debt.
That splurge to cover the group’s $800 meal may be completely impractical for someone who brings home $3,000 a month and needs every penny of that to cover rent, utilities, bills, and groceries.
A revolving credit line can make someone believe she has an extra $800 to spend once a creditor offers a $5,000 limit. The key to revolving credit plans is to pay the balance in full every month, whenever possible.
It is also important for credit card users to remember that a $50 blouse can easily turn into a $100 blouse if you put it on a credit card where you are not paying the balance in full.
The high-interest rates associated with credit cards are killers when it comes to staying on a budget and living within your means. It’s important to shop for a lower interest rate for your card before you sign up.
Here is where we clear up another common point of confusion among borrowers: “charge cards” are not the same thing as credit cards. Charge cards are a type of open credit, where the borrower agrees to pay a lump sum, and the charge must be paid in full to avoid penalties or cancellation.
A charge card does not always have a set limit; so, for example, if you have a good credit score you may be able to charge a $10,000 watch on this card. But you also have to pay it off in full when the bill is due the next month, so you must have the funds to cover your luxurious new timepiece.
Utilities work in an open credit system as well. In the same way, you can use a charge card for goods that you pay in full when the bill is due, a utility company offers you services (in advance) that you pay in full when the bill is due.
Credit Mix and Credit Scores
Credit mix is a factor in your credit score because it shows lenders you are able to handle a variety of financial obligations successfully. Having only one credit card, for example, does not give lenders a sense of your ability to juggle financial priorities.
The credit “mix” category accounts for 10% of your credit score. Factors such as payment history carry much more weight, with 35% of your score, but this does not mean you should ignore credit mix as a way to improve your score when you manage different types of accounts successfully.
The most important thing to remember is that you should only manage a mix of accounts you can truly afford. It is down to you to read all the fine print associated with any credit type to avoid steep penalties and fees and stick to a personal budget that ensures you can pay your bills on time, every time.