It’s crucial to understand the components that make up your credit scores. Five elements go into that all-important number:
- Payment history.
- Credit utilization, or how much of your credit limits you’re using.
- Number of recent credit applications.
- Length of credit history.
- Types of credit used.
The first two matter the most, but all are considered when FICO or VantageScore creates scores.
One of the least understood categories is that last one: types of credit. Credit bureaus not only want to see that you can handle credit responsibly, but also that you can handle different types responsibly. Risk assessment and risk management is so sophisticated that behavior among different credit types can be translated into various degrees of consumer risk.
Let’s take a quick look at each.
Snapshots of credit accounts
Revolving accounts are those that have different payments each month because you are charging different amounts every month. These are generally credit cards. If you don’t pay in full each month, you’ll accrue interest.
Installment accounts are different. They have fixed payments each month, and are often secured by some kind of asset, such as a car or house, but not always. You don’t have to pay the account in full each month, but you must pay the required payment amount. In this case, the interest charges were built-in at the start of the loan and are usually amortized throughout the life of the loan. This includes mortgage loans, auto loans and student loans, among others.
Open accounts don’t have a formal credit limit, but you must pay each off in full every month or you’ll forfeit some kind of service. This is your cell phone account or your utility account. Not all of these open accounts report to the credit bureaus.
Types of credit: It’s not that simple
Although there appears to be a degree of simplicity involved in the types-of-credit category, it is actually rather complicated to quantify the actual effect on your score. It isn’t just the number of each type of account you have, but how each account relates to others among all categories, and how they interrelate with the other score factors.
At one time, I had 12 credit card accounts, a mortgage, a home equity line, an auto loan and a student loan. They all had excellent payment histories, but different balances among them all, different terms and different interest rates. The effect these had on my score would differ from the effect they would have on someone else’s, even if they held the exact same types of accounts, terms, balances and interest rates.
In general, the more diverse the types of credit you have, the better. However, there are a few specific steps that you can take to maximize the good effects on your score and minimize the bad effects.
Guidance on types of credit
The best type of credit you can have is a mortgage. Risk management history shows mortgages are paid by those who are very responsible.
You’ll want to avoid non-prime finance companies, like rent-to-own companies or companies that offer signature loans. These are higher rate loans anyway and should be avoided. If you use one, it tips the bureaus that you may be having trouble getting traditional credit.
If you are going to collect credit cards, especially for rewards, don’t apply for too many at once. It’s OK to have a lot of cards as well as a lot of credit, just try not to max them all out.
Finally, consider an auto loan if you need to squeeze a few more points out of your score to push you into a higher score category. It’s more expensive to pay interest, but the payments may make obtaining other cheap credit worth the trade-off.
This article updated Feb. 22, 2017.