Introduction
Credit plays a crucial role in your financial well-being. Whether you're applying for a mortgage, financing a car, or opening a new credit card, your credit history determines your ability to borrow and the interest rates you receive. To make informed financial decisions, you need to understand the three main types of credit: revolving credit, installment credit, and open credit. Each affects your credit score differently and comes with its own benefits and risks.
What is Credit?
Credit is an agreement between a lender and a borrower, allowing the borrower to purchase goods or services with a promise to pay later. This system enables individuals to afford major expenses by spreading payments over time. However, borrowing comes with a cost—interest. The amount of interest you pay depends on factors like your credit score, loan type, and repayment terms.
A good credit score can help you secure loans with favorable interest rates, while a poor credit score can make borrowing more expensive or even prevent you from accessing credit. Your credit history is tracked by the three major credit bureaus—Equifax, Experian, and TransUnion—who update your credit report monthly. Lenders use this report to assess your creditworthiness.
The Three Main Types of Credit
There are three primary types of credit: revolving credit, installment credit, and open credit. Each type impacts your credit score in different ways and is structured uniquely.
1. Revolving Credit
Revolving credit allows borrowers to repeatedly access funds up to a set limit. The most common example is a credit card. With revolving credit, you can carry a balance from month to month, but any unpaid balance accrues interest.
Examples of revolving credit include:
- Credit cards
- Retail store cards
- Personal lines of credit
- Home Equity Lines of Credit (HELOCs)
The key features of revolving credit include:
- Flexible borrowing: You can use and repay funds repeatedly within your credit limit.
- Minimum payments: You must make at least the minimum payment each month, but paying only the minimum can lead to long-term debt due to interest accumulation.
- Credit utilization impact: Your credit score is influenced by how much of your available credit you use. Keeping your credit utilization below 30% is recommended for maintaining a good score.
2. Installment Credit
Installment credit involves borrowing a fixed amount and repaying it in equal installments over a specified period. These loans often come with fixed interest rates, making them predictable and easier to budget for.Examples of installment credit include:
- Mortgages
- Auto loans
- Student loans
- Personal loans
The key features of installment credit include:
- Fixed payments: Monthly payments remain the same throughout the loan term.
- End date: Once you complete the scheduled payments, the loan is paid off.
- Impact on credit score: Timely payments can improve your credit score, while missed payments can significantly damage it.
Many installment loans, like auto loans and mortgages, are secured—meaning they require collateral. If you fail to repay the loan, the lender can repossess the asset (e.g., car or home). On the other hand, personal loans and student loans are typically unsecured, meaning they don’t require collateral but may have higher interest rates due to the added risk for lenders.
3. Open Credit
Open credit does not have a set borrowing limit but requires full repayment at the end of each billing cycle. Unlike revolving credit, open credit does not allow you to carry a balance.
Examples of open credit include:
- Charge cards (such as American Express charge cards)
- Utility bills (electricity, water, gas, etc.)
The key features of open credit include:
- Full balance due monthly: Unlike credit cards, which allow minimum payments, open credit accounts must be paid in full each month.
- No preset spending limit: Some charge cards don’t have a strict credit limit, but spending behavior influences the amount available for future purchases.
- Limited impact on credit score: Utility bill payments typically don’t appear on credit reports unless they are overdue and sent to collections. Some newer credit models, however, consider utility payments in scoring calculations.
How Each Type of Credit Affects Your Credit Score
Your credit score is influenced by how you manage different types of credit. The five main factors that determine your FICO® credit score are:
- Payment History (35%) – Paying bills on time is the most critical factor in your credit score. Late payments can significantly lower your score.
- Credit Utilization (30%) – This refers to how much of your available credit you're using. High credit utilization on revolving accounts can hurt your score.
- Length of Credit History (15%) – A longer credit history helps boost your score, as it demonstrates consistent borrowing behavior.
- Credit Mix (10%) – Lenders like to see a mix of credit types (installment, revolving, and open credit) in your report. Having different credit accounts shows you can manage various forms of debt responsibly.
- New Credit (10%) – Opening too many new credit accounts in a short period can negatively impact your score due to multiple hard inquiries.
The Best Credit Mix for a Strong Credit Score
While you don’t need all three types of credit, having a diverse credit mix can strengthen your credit score. Lenders prefer borrowers who can manage multiple types of credit responsibly. However, this doesn’t mean you should open new accounts just to diversify your credit mix. Instead, focus on managing your existing credit well by making on-time payments and keeping balances low.
How to Build and Improve Your Credit
If you’re looking to build or improve your credit, here are some key strategies:
- Pay bills on time: Since payment history is the largest factor in your credit score, always make at least the minimum payment by the due date.
- Keep credit utilization low: Aim to use less than 30% of your total available credit to maintain a healthy credit score.
- Limit new credit applications: Each hard inquiry can lower your score slightly, so apply for new credit only when necessary.
- Monitor your credit report: Check your credit report regularly for errors and dispute inaccuracies.
- Use a credit-building tool: If you have limited or poor credit, a credit-building product like Ava Finance can help. Ava Finance offers tools that allow you to build credit with responsible borrowing while monitoring your progress.
Final Thoughts
Understanding the three main types of credit—revolving, installment, and open credit—is essential for managing your financial health. Each type serves a unique purpose and affects your credit score differently. To build a strong credit profile, aim for a healthy mix of credit, maintain low balances, and prioritize on-time payments.If you’re looking for a smart way to build or improve your credit, Ava Finance can help. With tools designed for credit growth and financial stability, Ava Finance makes it easier to manage credit responsibly and reach your financial goals.
