Having a mix of credit products in your name — such as a couple of credit card accounts and a mortgage or auto loan — helps to strengthen your overall credit profile.
These credit products fall under two main categories: revolving credit and installment credit. Lenders like to see that you have both because it shows them you can manage the many different obligations that come with borrowing all kinds of debt.
While these two kinds of credit are different, one is better than the other when it comes to improving your credit score. No matter the size of the balance, the interest rate or even the credit limit, revolving credit is much more reflective of how you manage your money than an installment loan.
Below, CNBC Select spoke to a credit score expert to understand the difference.
Revolving vs. installment credit: Which should you have?
To maintain a good credit score, it's important to have both installment loans and revolving credit, but revolving credit tends to matter more than the other.
Installment loans (student loans, mortgages and car loans) show that you can pay back borrowed money consistently over time. Meanwhile, credit cards (revolving debt) show that you can take out varying amounts of money every month and manage your personal cash flow to pay it back.
Lenders are much more interested in your revolving credit accounts, says Jim Droske, president of Illinois Credit Services. So while you may have a large auto loan of over $20,000, lenders look much more closely at your credit cards — even if you have a very small credit limit.
"Assuming both obligations are always paid as agreed, a credit card with a $500 limit can have a greater impact on your credit scores versus a $20,000 auto loan," Droske tells CNBC Select.
It's important to pay both bills on time each month, as on-time payments make up 35% of your credit score. But only credit cards show if you'll be a reliable customer in the long run, he explains. Because your balance is constantly in-flux, credit cards demonstrate how well you plan ahead and prepare for variable expenses.
"Credit scores are predicting future behavior, so the scoring models are looking for clues of your good and bad history," Droske (who has a perfect credit score) says.
With a credit card, your balance could be under $1,000 in one month, then three times as large the next. If your history shows that you manage your money consistently enough to cover varying costs, then lenders know you're probably reliable enough to borrow more money in the future.
Why a $500 credit limit has bigger impact on your credit score
Having both an auto loan and a credit card in your name will impact your credit score, but the revolving credit account (your credit card) will play a bigger factor in your score's calculation. Here's why:
- Reason 1: Revolving credit is highly influential when calculating your credit utilization rate, or the percentage of your total credit that you're using. Your credit utilization is the second biggest factor (after payment history) that makes up your credit score. As you keep paying off your revolving balance on your credit card, your credit score will go up and you'll free up more of your available credit. Whereas with an installment loan, the amount you owe each month on the loan is the same, and the total balance isn't calculated into your credit utilization.
- Reason 2: Revolving credit has more of an impact on your credit score because it also offers more "financial clues" into your behavior than installment credit does, Droske says. With a $20,000 auto loan, the borrower can only behave in so many ways: Either they make the monthly payment on time over the term of the loan or they don't. On the other hand, borrowers can make lots of decisions when using a credit card — charge a little and pay the minimum, max it out and pay it off entirely, don't use it at all. How you manage your variable debt tells lenders a lot about how you'll manage future debt you don't have yet.
If you don't have either, start with a credit card first
If you don't have any credit accounts in your name, and you want to build your credit history, it's best to start with a credit card designed for newcomers.
CNBC Select ranked the best credit cards for building credit, and the Petal® 2 "Cash Back, No Fees" Visa® Credit Card topped the list for the best starter credit card for a few reasons.
First, the Petal 2 Visa Credit Card allows applicants with no credit history to apply, and there are no fees whatsoever*. If you have a credit file, it does factor into the credit decision. It also has a rewards program meant to help you establish good credit habits: 1% cash back on eligible purchases right away, which can increase up to 1.5% cash back after you make 12 on-time monthly payments. This is a great perk that can get you in the routine of making monthly bill payments on time. Plus, Petal offers 2% to 10% cash back from select merchants.
Another card to consider is the Capital One Platinum Secured Credit Card, which has a low security deposit (learn how secured credit cards work) and the Capital One Platinum Credit Card, which is good for applicants with average credit.
At the end of the day, the most important factor is that you use your credit products to your advantage. Feel free to charge expenses on your credit card to earn points or cash back; just make sure you can pay the balance off in full by the time the bill comes. The same goes with installment loans like personal loans, car loans and mortgages.
"In the long run, always pay your installment loans on time," Droske says.
Petal 2 Visa Credit Card issued by WebBank.
*The regular APR for the Petal® 2 "Cash Back, No Fees" Visa® Credit Card currently range from 18.24% - 32.24% (variable).
