Do you have a revolving credit line or installment loan on your credit report right now? Do you know the difference between the two? Don’t worry if you’re confused, we’re about to clear things up. If you already have a basic understanding of how your credit score is determined, then you’re ready to move on to the more advanced stage of understanding about your credit health.
What is a Revolving Credit Line?
A revolving credit line is exactly as it sounds. You open a line of credit and have access to a credit limit. You can use as much or as little of that credit line as you’d like. Obviously, this sounds exactly like a credit card. In fact, credit cards are considered revolving credit lines. But there are other forms of revolving credit as well. A home equity line of credit, or HELOC, is also an example of a revolving credit line.
What is an Installment Loan?
An installment loan is a predetermined amount of credit distributed to a borrower that is paid pack in equal amounts every month. Loan payments include principal (the amount originally borrowed), any fees charged by the lender for originating the loan, and interest, as determined by your annual percentage rate (APR). The most common examples of installment credit are personal loans, mortgages, student loans, and car loans.
Impact on Your Credit Score
The calculation behind your credit score is complex, but understanding the difference between revolving credit lines and installment loans can be helpful. Each has a different impact on your credit history report and ultimately, your credit score.
The first and most important factor that determines your credit score is your payment history. All financial companies, including the ones servicing your credit lines, report your monthly payments to the respective credit bureaus who calculate your credit score.
In the United States the major consumer credit reporting agencies are Experian, Equifax and TransUnion. The primary business credit bureaus are Experian, Equifax, and Dun & Bradstreet (DNB).
The biggest chunk of your credit score is determined by how often you make on-time payments towards your debts. Miss more than two payments and you should expect a major hit against your credit score. Between revolving credit lines and installment loans, not much is different in the impact on your credit score.
Distinct Differences Between Revolving and Installment Credit on Your Score
But there’s an interesting difference between revolving credit lines and installment loans over time. That is your credit utilization ratio.
Credit Utilization Ratio
Credit utilization ratio plays an important role in determining your credit score. Your credit utilization is your current outstanding debts owed calculated as a percentage of your total credit limit. So, if your credit limit is $10,000, and you have a balance of $2,000, your credit utilization is 20 percent.
Revolving Credit Lines – Utilization is a Factor
Generally, a credit scoring systems will begin shaving a decent amount of points off your credit score once you reach the 30 percent utilization threshold. If you have a credit card, which is a type of revolving credit, and you have a low limit, but you spend too much too quickly, your credit score is going to take a moderate hit.
Even small amounts of spending will bring your credit score down, albeit very lightly. However, if you pay off the balance each month, making your payments on time, that will help bring your credit score up overall.
Installment Loans – Utilization is not a Factor
In the case of installment credit, such as a mortgage, the total size of that loan and how much you have left to pay back is not factored into your credit utilization score. Each time you make a payment your overall balance is reduced leaving no freed up credit to utilize.
Say you have taken out a mortgage of $280,000 and so far you have paid $50,000 towards it. You still have $230,000 left to pay back, or about 82 percent of the total loan. But your total credit utilization will not take into account this $230,000 if the credit line is installment based, meaning your credit utilization will not be 82 percent.
Because of this, installment loans can be less damaging, from month-to-month, on your credit score than revolving forms of credit.
Payment History, Length, and Credit Mix
Taking out a loan, credit card or other line-of-credit will definitely ding your credit score initially, but making regular on-time payments to those accounts will help bring your credit score higher in the long-run as payment history, length-of-credit, and credit mix are also credit scoring factors with payment history being the most significant.
Final Thoughts on Installment Loans vs. Revolving Credit Lines
With both types of credit, responsible and on-time payments are required to maintain a good credit score. Late payments are terrible so try your best to avoid them. Missing a payment with any type of credit account is one of the worst things you can do because it will negatively affect your credit report and score for years.
