Credit scores are determined based on a variety of factors, and credit mix determines 10 percent of your score. What does this mean exactly? Well, there are two main types of credit that can be extended to you: revolving credit and installment credit.
John Ulzheimer, president of consumer education at CreditSesame.com, defines revolving credit as "any account where you can make a payment less than the full balance due and carry some amount over to the next month."
"The balance due fluctuates month after month as payments are made, credits are applied, interest and fees are applied, and new charges are made," he says.
The most common types of revolving credit are credit cards and home equity lines of credit (HELOCs).
Anthony Sprauve, senior consumer credit specialist at FICO, points out that credit utilization accounts for 30 percent of your FICO score. In other words, although you can borrow up to the limit on a revolving credit account, it's better not to. The National Foundation for Credit Counseling's 2014 Financial Literacy Survey revealed that 15 percent of American adults -- roughly 35 million people -- carry $2,500 in credit card debt over from month to month. Sprauve recommends using less than 30 percent of the credit limit on a revolving account and paying off your balance in full each month.
Installment accounts work differently.
"There's a difference between credit and debt," says Maxine Sweet, vice president of public education for Experian. "With a credit card, you determine how much you charge each month. An installment loan is a debt that is paid back over time."
Examples of installment debt are auto loans, mortgages and student loans. According to Sweet, having a good history with revolving credit will help you qualify for the best interest rate when you do decide to take on debt.
Let's say that your bank or credit union loans you $20,000 so you can buy a new car, and you opt for a 60 month (5 year) payment plan. If you have a good credit score, you may pay an interest rate of 1.99 percent, in which case your monthly payment will be about $350. On the other hand, if your credit score is low, you might have to pay an interest rate of 10 percent, which makes your monthly payment almost $425. Over 5 years, that's an additional $4,500 for the same car! The difference becomes even more significant when applied to mortgage rates.
Types of credit and your credit score
The credit scoring model rewards what Ulzheimer calls "diversity," meaning that ideally, you want to have both revolving and installment accounts as part of your credit history. However, Sprauve clarifies that it is possible to have a good FICO score without this diversity.
"There's a bit of a myth that you have to have both revolving and installment accounts to have a good score," he says. "You can start with a credit card and manage it responsibly. You shouldn't open credit just to have it."
Credit mix isn't the biggest factor in determining your credit score. However, making sure you have a positive history with all your accounts is important, especially if you have a thin credit file. According to Gail Cunningham of the National Foundation for Credit Counseling, the good news is that "if a person only does two things right, pay their bills on time and not utilize more than 30 percent of their available credit, depending on their situation, it is likely that their credit score will improve."
If you're wondering how your credit stacks up, WisePiggy offers a service that provides your truly free credit score.