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We spend a lot of time in this column talking about credit scores and how they work. This week we are going to look at revolving credit with an emphasis on credit cards and see what they mean to your credit score.
What is revolving credit?
Revolving credit, also known as open-end credit, is how most credit cards work. There are other types of credit that count as revolving (like credit lines), but cards are the most common type.
You’re granted an amount of credit, with a limit say of $5,000. It’s yours to use any way you want. You choose how much of the limit to use at any given point in time. As you use the card, you must make payments on time and for the amount agreed. As you make payments, the amount that goes to principal recharges the line. You can pay off the entire amount, restoring the line to its original and full amount, or you can just pay what your spending plan will allow, or even make just the minimum payment. You get to decide.
Revolving credit vs. installment credit
This arrangement differs from installment credit in several ways. Installment credit (closed-end credit) is frequently used by department and furniture stores, in addition to mortgages, car and student loans. This type of credit involves loaning an amount equal to the specific amount of a purchase that you repay in fixed installments. One major distinction to remember about installment credit is that it is a one-time thing. Your loan, once repaid, cannot be tapped again. While you may get another loan from the same creditor, it won’t be a continuation of the first loan but will be a new loan altogether.
Before concentrating on just credit cards, let me say that having different types of credit counts in the scoring category called credit mix. This factor makes up about 10 percent of your FICO score. While that may not seem like much, you should know that if your file is “thin” (meaning you don’t have a lot of information in your credit file), this factor can make more of a difference. And when it comes to your VantageScore, credit mix is combined with credit age (or experience) and is considered “highly influential” in its scoring matrix. So, this is not a factor that should be discounted or dismissed.
Credit mix looks at what types of credit you have; having a healthy mix is what is best for your credit score. To understand this, recall that there are two main types of credit—installment and revolving. Demonstrating an ability to handle both variable (revolving) and fixed (installment) payment types of credit responsibly is what the credit scoring elves are looking at when they evaluate your credit mix. Showing you can keep up with both types of payments every month will give you the most points in this category.
How does revolving credit affect your credit score?
Credit card purchases have a direct impact on the credit utilization portion of your score. This factor is second only to payment history in importance to your FICO score (worth about 30 percent) and is “extremely influential” to your VantageScore. Credit utilization looks at how much of your available credit you have used. As noted above, you have the choice of how much you will pay on your credit cards each month, but you do need to know how that decision will affect your utilization factor and overall score.
Installment loans do not affect credit utilization because your loan is for a specific amount and, as also noted above, you cannot access the funds again.
This is actually one of the selling points of an installment loan to pay off credit card debt. If you can obtain a loan with a lower interest rate than your credit card(s), you will immediately lower your credit utilization ratio, as long as you don’t close those credit card accounts. If you close your cards, you may increase your credit utilization and lower your score. To quickly determine this percentage for yourself, check out Bankrate’s credit utilization ratio calculator.
How to use revolving credit without hurting your score
Revolving credit, like credit cards, can certainly hurt your credit score if it is not used wisely. However, having credit cards can be great for your score if you manage both credit utilization and credit mix to your best advantage. The trick is to figure out the best way to use the credit cards you have so that you not only don’t hurt your score, but boost it as well.
You do this first by making your payments on time, as agreed, each and every month. You also keep an eye on where your cards are in terms of available credit and how much you have used. I recommend never going beyond 25 percent of any card’s credit limit. The lower you can go, the better it will be for both your score and your overall financial health.
People with great credit scores tend to have utilization ratios in the single digits. If you have multiple cards, consider paying one or two just before your statement closes, or at least sooner than the due date. Issuers tend to report account information around the time the billing statement closes, so getting your credit utilization as low as it can be around this time will help your score.
The bottom line
Both installment and revolving credit have a place in helping you achieve the credit score you want. Showing you can responsibly handle both types will put you well on your way to that goal. Good luck!