Your credit score is a measure of how well you have managed the borrowed money and lenders use it to determine how much risk you have to borrow. their money. Manage a loan responsibly and it should improve your credit score. But not all loans have the same effect on your score. In fact, the loans that have the greatest potential to get you into trouble also have the greatest potential for increasing your credit score.
Types of loans
There are many types of loans, but for this discussion we will focus on two broad categories.
Installment loans such as mortgages, auto loans, student loans and personal loans. With an installment loan, the lender decides how much you can borrow and how much you need to repay each month. You generally cannot borrow additional money on the same loan, and you have little flexibility in payments.
Renewable loans such as credit cards and home equity lines of credit. With revolving loans, the lender decides the size of your line of credit, but you decide how much you will use. You choose how much to borrow, when to borrow and how much to repay at any given time, as long as you make a minimum payment each month. You can borrow money from the line of credit, pay it off, and borrow again as many times as you want.
Greater freedom, greater influence
When lenders look at your credit history and credit score, they’re trying to predict how well you’ll handle new credit if they extend it to you.
Installment loans show that another lender has found you creditworthy in the past and that you can make the payments on time. It definitely helps build your credit history.
Revolving accounts such as credit cards provide even more information. Because credit cards give you the flexibility to borrow, repay, and borrow again, they more effectively demonstrate your credit management skills. This makes it a better predictor of how you’ll handle credit in the future, says Rod Griffin, director of public education at Experian.
With a credit card, “you are exercising your agency,” Griffin says. “It gives the scores a little more weight because it’s more predictive of how you make individual credit decisions.”
The risk with using revolving loans is that they usually have higher interest rates than installment loans. If your balance climbs too high, it can be difficult to pay off debt because more of your monthly payment is spent on interest than on reducing what you owe. By using a credit card responsibly and not losing your mind, lenders can trust you with additional loans.
Can you create credit without a credit card?
There is no rule that says you must having a credit card to have good credit, and you certainly don’t need to have a balance on a credit card once you get it. But a revolving account can help future lenders see your full potential as a borrower.
Griffin offers a simple formula for creating credit with a credit card.
“If you can get a credit card – one credit card, maybe two – make one small purchase, pay it off in full every month. It will help you build that credit history and build credit a bit faster, ”he says.
For many, getting a credit card approved is easier said than done. If you have bad credit or no credit, a good strategy is to start with secure credit card, which requires a security deposit. But it’s not enough to just grab the card and stick it in your wallet. To fully show lenders that you can handle flexible credit accounts, you need to use it regularly and make your payments on time.
“It’s not that you can’t have good credit scores with just installment loans,” Griffin says. “It’s just that a credit card … gets you there a little faster.”