Do I Need Installment Credit In My Credit Mix?
If you review your credit report(s)—like you should at least annually—you may notice a preponderance of revolving credit accounts, or tradelines. And the majority of those are probably credit cards, unless you’ve opened a revolving line of credit with a financial institution.
But what about installment credit, which includes mortgages, auto loans, student loans, and personal loans? Should you also have some of those in your credit file to make it more diverse and well-rounded?
Glad you asked.
Just like with many other things—investment portfolios, workplaces, educational institutions, etc.—diversity can be a good thing in a credit report. A mix of revolving and installment credit could result in a higher credit score and, if you manage both responsibly, paint you as someone who can handle both types of credit to potential lenders.
But just how important and influential is your credit mix in determining credit score?
What’s the Difference Between Revolving and Installment Credit?
Revolving credit is open-end credit, meaning you can keep using it so long as the account is in good standing and you have credit available. It continually renews unless the account is closed or, in the case of a line of credit, its draw period expires.
So, if you have a credit card with a $2,000 credit limit, and the account is open and current, you can keep making purchases with the card up to that credit limit. Let’s say you have an outstanding balance of $1,500 on that card. That means you still have $500 in available credit. But, if you make an on-time payment by your payment due date, then you should have more available credit, depending on how much you pay. For example, if you make a $500 payment, that should knock your outstanding balance down to $1,000, netting you $1,000 in available credit. But available credit doesn’t go away unless you reach your credit limit or the account is closed.
Installment credit, on the other hand, is closed-end credit, meaning it expires once you’ve paid it back in full. If you want more installment credit after that, you’ll have to apply for a new loan. The interest rate you pay and the amount you owe each month on an installment loan typically stay the same—unless you have a variable rate loan, where interest rates can fluctuate throughout the term of the loan.
So, say you take out an automobile loan for $10,000 with a three-year term at a 5% interest rate. Every month, for three years, you’ll pay a pre-determined amount until the balance—plus interest and any fees—has been paid in full. Once the loan is paid off, it’s closed.
The Weight of Credit Mix in Determining Credit Score
With the two main consumer credit scoring models—FICO® Score and VantageScore®—credit mix plays a role in calculating your score, but it’s not the most important criteria. For both of these models, payment history is the most important factor.
With FICO Score, credit mix accounts for 10% of your score. VantageScore doesn’t break credit mix out as a separate category but instead incorporates it into the category “Age and Type of Credit,” which makes up 21% of your credit score.
But your credit mix can affect your credit score in other ways as well:
- Installment Credit Can Contribute to Your Payment History
If you have a mortgage that you pay each month, that could result in decades of solid payment history before that loan is paid in full. Most car loans don’t have terms as long, but making consistent, on-time payments on a vehicle for a year or more can also contribute to a positive payment history.
As mentioned, payment history is the number-one factor in determining your credit score, so the better that history is, the better it is for your credit score. And installment loans hold a distinct advantage over revolving credit for building payment history because a payment on an installment loan is due every month. So, you get 12 opportunities a year to make an on-time payment. With revolving credit, like a credit card, there may be times when you don’t use it, so you’re not making any payments. Installment credit payments are typically more consistent and regular than revolving credit.
- Installment Credit Could Be Used to Lower Your Credit Utilization Ratio
Your credit utilization ratio is an important ratio used in determining your credit score. It measures how much revolving credit you’re using in relation to how much revolving credit you’ve been granted. Lower credit utilization can contribute to a higher credit score. The actual formula for calculating this ratio is:
SUM OF OUTSTANDING REVOLVING CREDIT
SUM OF REVOLVING CREDIT LIMITS
“Revolving” is the key word because installment credit is not considered in calculating credit utilization. This means you could conceivably reduce this ratio by converting some of your revolving credit debt into installment debt.
By taking out a personal loan, which is installment credit, and using those funds to pay down your revolving credit outstanding balances. Say, for example, you have $5,000 in outstanding revolving credit and the sum of your revolving credit lines is $10,000. That’s a credit utilization of 50% ($5,000 ÷ $10,000), which is 20% higher than the 30% maximum many experts recommend. Well, if you took out a $5,000 personal loan and used, say, $4,000 of that loan to pay down your revolving credit balance, your credit utilization ratio would drop to 10% ($1,000 ÷ $10,000), which is an attractive ratio and could give your credit score a boost.
What’s more, you could also get a boost for diversifying your credit mix. On top of that, if the interest rate you get on a personal loan is lower than what you’re paying on credit card debt, you could save money as well!
So, Should I Take Out an Installment Loan to Improve My Credit Mix?
Unless you actually need a loan to finance something—pay down debt, buy a home or car, go to school, etc.—it’s probably not a great idea to take out an installment loan just to improve your credit mix. While having some installment credit in your mix is ideal, revolving credit is typically more influential in determining your credit score because, as mentioned, it determines your credit utilization ratio.
Revolving credit generally also provides potential lenders with a more accurate read on how you manage your credit because you play a more active role with revolving credit than with installment credit. With installment credit, once it’s granted, you either make your monthly payment on time or you don’t. But, with revolving credit, you determine how much of it you use each month, what your credit utilization ratio will be, and how much you opt to pay back each month—the entire balance, the minimum amount due, or somewhere in between.
It’s worth mentioning that, if you have little or no credit history and need to build a history, then it could be worth your while to take out one type of installment credit: a credit-builder loan. With this type of loan, you make monthly payments on a smaller principal, including interest, but you don’t get the money until you’ve paid the loan amount in full. The lender, in turn, reports your payment activity to one, two, or all three of the credit bureaus, and that activity shows up in your credit report(s). It may sound counterintuitive to make payments on money you don’t get up front, but the purpose of the loan is not to get money—it’s to help you build a payment history.
So, if you don’t currently have any installment credit in your credit mix, don’t sweat it. Besides, installment credit has a way of working its way into people’s lives when they need to make major purchases like cars, homes, or higher education. Chances are, if you find yourself in the market for any of these, you’ll take on some installment credit organically.