The Three Types of Credit and Why It's Vital to Know How They Affect Your Credit Score
Understanding credit is one of the most important components of being financially responsible as an adult. There are three types of credit that can affect your credit score, and understanding what each one is and how each one works is very important. For a review of the three types of credit, as well as how they can help improve your credit score, read on.
Installment credit accounts are one of the most basic forms of credit. Installment credit is any credit that is paid off over a period time in the form of installments, or small portions of the total amount. In most cases, installment credit is paid off over the course of five, ten, fifteen, or thirty years, and allows the borrower to pay a fixed sum of money each month, with interest, over the course of the loan agreement time. Common types of installment credit are auto loans, student loans, mortgages, home equity loans, and signature loans. If you pay your monthly installment on time each month and in full, your credit score will slowly improve over time. On the other hand, if you default on a payment or don't pay the full amount when it's due, your credit score can be severely penalized.
Revolving credit is very different from installment credit; instead of focusing on a fixed amount that's due at the same time each month, revolving credit is contingent upon how much you borrow each month. For example, a credit card is a type of revolving credit. You may owe $50 on your credit card each month, or you may owe $500—it just depends on how much you spend. Additionally, revolving credit requires you to pay only a portion of the amount that you've spent, rather than paying the amount in full each month.
If you pay your credit card bill late, your credit score will be negatively impacted. And, the later you pay it, the worse the impact will be. Paying your bill up to 30 days late will receive a small penalty, and the penalty gets more severe with each month that passes. If you don't pay the bill at all, your account will eventually be handed over to a collection agency—if this happens, your credit score is in severe jeopardy. Conversely, opening a credit card, spending wisely and paying your bill in full each month is a great way to boost your credit score.
Open credit is less common than installment credit or revolving credit, and refers to credit that's due in full each month and has no credit limit. For example, home utility bills can vary from $60 to $600 each month (because there is no limit on how much water/gas/electricity/etc. you can use), but the full amount is due at the end of the month regardless of how much you spend. Cell phone bills are another example of open credit. Utility bills and other forms of open credit are the least likely to impact your credit score in a dramatic way, but including utility payments on credit reports is slowly becoming more common in the U.S.
Improving Your Credit Over Time
In order to improve your credit over time and maintain a good credit score, it's important that you utilize all three forms of credit. However, make sure you never borrow more than you can afford. Additionally, the easiest way to improve your credit score is to pay your bills in full each month regardless of how much is due, and to always pay your bills on time.
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