Having a mix of credit products in your name—such as a few credit card accounts and a mortgage or car loan—will help strengthen your overall credit profile.
These loan products fall into two main categories: revolving loans and installment loans. Lenders want you to have both because it shows them that you can handle the many different obligations that come with taking on all kinds of debt.
Although these two types of loans are different, one is better than the other when it comes to improving your credit score. Regardless of the amount of the balance, the interest rate, or even the credit limit, a revolving loan is a much better reflection of how you manage your money than an installment loan.
Below, CNBC Select spoke to a credit score expert to understand the difference.
Revolving Credit vs. Installment Loan: Which Should You Have?
To maintain good credit, it is important to have both installment loans and revolving loans, but revolving loans tend to be more important than the others.
Installment loans (student loans, mortgages, and car loans) show that you can repay borrowed money consistently over time. Meanwhile, credit cards (revolving debt) show that you can withdraw different amounts of money each month and manage your personal cash flow to pay the money back.
Lenders are much more interested in your revolving credit accounts, says Jim Droske, president of Illinois Credit Services. So while you may have a large car loan of over $20,000, lenders will look at your credit cards much more closely – even if your credit limit is very low.
“Assuming both obligations are always paid as agreed, a credit card with a $500 limit can have a greater impact on your credit score than a $20,000 car loan,” Droske tells CNBC Select.
It’s important to pay both bills on time each month, as on-time payments account for 35% of your credit score. But only credit cards show whether you are a reliable customer in the long term, he explains. Because your balance is constantly in flux, credit cards show how well you plan ahead and prepare for variable expenses.
“Credit scores predict future behavior, so the scoring models look for clues about your good and bad past,” says Droske (who has a perfect credit score).
With a credit card, your balance can be under $1,000 one month and triple that the next month. If your history shows that you manage your money consistently enough to cover various costs, lenders will know that you are likely reliable enough to borrow more money in the future.
Why a $500 credit limit has a bigger impact on your credit score
Having both a car loan and a credit card in your name will impact your credit score, but the revolving credit account (your credit card) plays a larger role in calculating your credit score. Here’s why:
- Reason 1: Revolving credit has a big impact on calculating your credit utilization ratio, or the percentage of your total credit that you use. Your credit utilization is the second largest factor (after payment history) that determines your credit score. As you continue to pay down your revolving balance on your credit card, your credit score will increase and you will be able to free up more of your available credit. With an installment loan, however, the amount you owe on the loan each month is the same and the total balance is not factored into your credit utilization.
- Reason 2: Revolving credit has a greater impact on your credit score because it also provides more “financial clues” about your behavior than installment credit, says Droske. With a $20,000 car loan, the borrower can only act in a number of ways: either they make the monthly payment on time over the life of the loan, or they don’t. On the other hand, borrowers can make many decisions when using a credit card – charging something and paying the minimum amount, maxing it out and paying it off in full, not using it at all. How you handle your variable debts tells lenders a lot about how you will handle future debts that you don’t already have.
If you don’t have either, start with a credit card
If you don’t have a credit account in your name and want to improve your credit score, your best bet is to start with a newbie credit card.
CNBC Select ranked the best credit cards for building credit, and the Petal® 2 Cash Back, No Fees Visa® Credit Card topped the list of best credit cards for beginners for several reasons.
First, the Petal 2 Visa Credit Card allows applicants to apply with no credit history and there are no fees whatsoever*. If you have a credit file, it will be taken into account when making a loan decision. There’s also a rewards program designed to help you establish good credit habits: 1% cash back on eligible purchases immediately, which can increase to up to 1.5% cash back after you make 12 on-time monthly payments. This is a great benefit that can help you make monthly bill payments on time. Additionally, Petal offers 2% to 10% cashback at select retailers.
Another card to consider is the Capital One Platinum Secured Credit Card (see rates and fees), which requires a small deposit (learn how secured credit cards work), and the Capital One Platinum Credit Card (see rates and fees), which is good for applicants with average credit.
In the end, what matters most is that you use your loan products to your advantage. Feel free to charge expenses to your credit card to earn points or get cash back. Just make sure you can pay the balance in full by the time you receive the invoice. The same applies to installment loans such as personal loans, car loans and mortgages.
“Always pay off your installment loans on time in the long term,” says Droske.
Do not miss: Revolving loan debt falls to $996 billion, the lowest level since the Great Recession
Petal 2 Visa credit card issued by WebBank.
*The regular APR for the Petal® 2 “Cash Back, No Fees” Visa® Credit Card is currently between 18.24% – 32.24% (Variable).
Editorial note: The opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial team alone and have not been reviewed, approved or otherwise endorsed by any third party.