Do you have a credit card, a mortgage, an auto loan, a student loan, or another type of credit obligation? You’re not alone; most people in the U.S. carry some type of debt. But what most people aren’t aware of is that not all debt is the same. Unfortunately, when it comes to credit, what you don’t know might be hurting you.
Here’s a deeper look at credit. What are the different types, and how does each type affect your credit score?
There are two types of credit: Installment and revolving. Many people have both types of these loans. Both installment credit and revolving credit have an effect on your overall credit score. The type of effect depends on many factors, which we’ll discuss below.
Installment credit is a fixed loan. A creditor will loan you a set amount of money, usually for a specific purpose. You’ll have to repay this money by a certain time, which you’ll know about before you agree to the loan.
These are the three most common types of installment loans:
Student loans are many people’s first experience with an installment loan. This type of loan can help a young person get a good start on building credit. Because the loan is a fixed amount, which is paid at the same time each month, this loan can be relatively easy to manage.
That doesn’t mean installment loans are worry-free. For instance, by 2023, an estimated 40% of borrowers will default on their student loans. CNBC reported that more than 40 million Americans together have close to $1.5 trillion in student debt that they're trying to pay off. This can be a heavy burden.
It’s important to understand that any type of loan that you’re unable to pay back can have serious consequences for your credit.
An installment loan can be secured or unsecured. Each type has certain advantages but also certain risks.
An unsecured loan has the highest interest rate of the two. Used mainly for small, short-term amounts, an unsecured loan is typically only available for people with a high credit score. The downside is the high interest rate, but the upside is the borrower doesn’t have to risk any personal assets. You would normally use an installment loan to pay for a wedding, a home-improvement project, or another one-time event.
A secured loan has a lower interest rate and is used for larger purchases, such as a car or a house. Unlike an unsecured loan, if you default on a secured loan, your personal assets are at risk. This could be repossession of a vehicle or even foreclosure on a house. That potential loss is the downside of a secured loan. The benefit is that this type of loan has a low interest rate and is relatively easy to obtain.
The good news is that installment debt doesn’t have a huge negative impact on your credit score, at least in the beginning. If you’re late on a car payment once, for instance, it’s not going to have a major effect on your score.
Serious problems can occur if you neglect an installment loan for too long. Foreclosing on your house is one of the worst things you can do to your credit. According to research by Zillow, this can lower your credit score by 200-300 points — sometimes more. The higher your score is to begin with, the greater a foreclosure can drop it.
Defaulting on student loans can also hurt your credit score, although the drop is less severe. One study found that, on average, borrowers who defaulted saw a drop of 50 to 90 points during the year or two prior to default. In most cases, defaults on installment loans can stay on your credit report for 7-10 years.
So, while the short-term credit problems you can experience with installment loans are relatively minor, the long-term problems can be deleterious.
Revolving credit involves a maximum credit limit. The two most common types of revolving credit are credit cards and a home equity line of credit. With revolving credit, the consumer has options when it comes to repayment. Once a month, the consumer
Any balance left will be carried over to the next month. If no payment is made, you’ll see an increase in your interest rate, and your debt can quickly snowball.
Revolving debt has more of an influence on your credit score than installment debt. Revolving debt is considered a more accurate indicator of someone’s credit riskiness. If you miss credit card payments or carry a large outstanding balance from month to month, you’ll be considered a fairly high risk.
Lenders can significantly reduce your credit limit — even freeze it — if you aren't able to make payments in a timely manner. If you've come to depend on this extra income, it can be a harsh reality when you're cut off.
The good news is the quickest way to improve your credit score is to pay down any revolving debt. We know that’s often easier said than done. But if you have to choose between different types of debt to focus on, make revolving debt your priority.
When it comes to credit, try to avoid getting in over your head. Before you take out any type of credit line, make sure you understand what type of debt you’ll be dealing with. Knowing how each type of credit works will help you avoid any problems down the road. So don’t be afraid of credit; with a little bit of understanding, credit can be a valuable tool to help create a brighter future.
For guidance, check out our additional tips for paying down debt, including: