When it comes to how your credit scores are calculated, there are many factors at play. Credit scoring models consider how well (or how poorly) you pay your bills. They also consider what kind of debt you have, and how much of it you’ve got.
The list goes on and on, but if you want to earn and maintain great credit scores, you’ll need to perform well across all of the various credit scoring metrics. That means understanding which factors matter, and matter the most, to your credit scores.
One such factor that often leaves consumers scratching their heads is the fact that credit scoring models like FICO and VantageScore will focus on the various types of accounts on your credit reports rather than just how well you pay them.
More specifically, the different types of debt you choose to carry will influence your scores differently. One type of debt may have very little impact on your credit score, while others can send your score spiraling in the wrong direction — even if you make every single payment in a timely fashion.
The Different Types of Debt
There are many kinds of accounts that can appear on your credit reports. These accounts may range from credit cards to student loans to mortgages, just to name a few. However, the majority of the of accounts on your credit reports can be classified into one of two categories: revolving accounts or installment accounts.
Installment Accounts
When you take out an installment loan, the terms of your loan will typically require a fixed monthly payment over a predetermined period of time. For example, your auto loan might require you to make monthly payments of $300 over a period of five years.
Some common types of installment accounts may include student loans, personal loans, credit builder loans, auto loans, and mortgages. And, most of the time these types of loans will be secured by some asset, such as a car or a home. The notable exception, of course, is a student loan.
Revolving Accounts
The most common type of revolving accounts are credit cards. Unlike installment loans where you borrow one time (upfront) and will likely make a fixed monthly payment throughout the life of the loan, revolving credit card accounts work quite differently. With a credit card account, you generally have a set credit limit and you can borrow up to that maximum limit on a monthly basis.
The borrower can either pay the account balance in full each month, pay it off partially, or make a minimum payment as required by the lender. And, you can continue to draw down against your credit limit as long as you make payments on time. This type of debt is almost never secured by an asset, unless it’s a revolving home equity line of credit.
How Credit Scoring Models View Your Debts Differently
Your payment history: FICO and VantageScore, the two most popular credit scoring models, both treat the installment debt and the revolving debt on your credit reports very differently. However, when it comes to any account on your credit reports, the most important factor considered in the calculation of your credit scores is whether or not you pay as agreed.
If your payment history shows late payments on any account, whether it be a revolving account or an installment account, the impact on your credit scores is likely going to be negative. A late payment on an installment account and a late payment on a revolving account would likely be similarly damaging to your credit scores. Late is late.
Amounts owed: The balances on your accounts (i.e., the amount of debt owed) are another matter when it comes to credit scoring. In this credit scoring category, installment debt and revolving debt are not treated equally.
Credit scoring models will pay a lot of attention to your revolving utilization ratios — that is to say, the relationship between your credit card limits and credit card balances. When you carry a high percentage of credit card debt compared to your credit card limits, your credit scores are going to almost certainly begin to trend downward.
Conversely, you can carry a large amount of installment debt, such as a mortgage loan, and the impact of the balance of the installment loan on your credit scores is likely to be very minimal. For that reason it’s completely possible for a small $5,000 credit card balance (especially on an account with a low credit limit) to have a much more damaging impact on your credit scores than a $500,000 mortgage balance. I know, that’s hard to believe.
The Reason for Different Treatment
Many consumers wonder why credit card debt, even if it is paid on time, can have such a potentially negative impact on their credit scores when installment accounts are not treated in the same manner.
The answer is simple: Revolving debt is much more predictive or indicative of elevated credit risk. As such, it’s going to be much more harmful to you credit scores.
Installment debt, which is almost always secured, is a much less risky type of debt, primarily because people know if they stop making their payments they can lose their car or their home.
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John Ulzheimer is an expert on credit reporting, credit scoring, and identity theft. He has written four books on the topic and has been interviewed and quoted thousands of times over the past 10 years. With time spent at Equifax and FICO, Ulzheimer is the only credit expert who actually comes from the credit industry. He has been an expert witness in over 230 credit related lawsuits and has been qualified to testify in both federal and state courts on the topic of consumer credit.
The post Revolving Debt vs. Installment Loans: Why the Type of Account Matters to Your Credit Score appeared first on The Simple Dollar.
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