Depending on how you manage it, revolving credit can either be a major drain on your finances or a smart tool to help you improve them. Either way, it’s a factor in determining your credit score. That’s why it’s important for you to understand what revolving credit is and how it works so you can figure out how it best fits with your financial style and long-term financial plan.
What is revolving credit?
Revolving credit is a type of loan that allows you to continuously borrow from and repay the lender up to a certain amount, and you only get charged interest on the debt if you carry a balance. The most common example is a standard credit card, but personal lines of credit and home equity lines of credit (HELOCs) also fall into this credit category.
What are the other types of credit?
Installment loans are the other major type of credit. They let you borrow a set amount of cash, typically to help you make a specific purchase. Mortgages, auto and student loans are good examples of installment loans. A personal loan is another example that doesn’t specify exactly how you need to use the cash.
Other lesser-known types of credit include open credit and service credit. A good illustration of open credit is a charge card, which is like a credit card that you have to pay in full every month. Examples of service credit include any contractual agreement you have with a service provider, like your water or cell-phone company. Service credit is not often reported to the credit bureaus.
You don’t have to carry all the different types of credit, but having a nice mix of them can help boost your credit score. It might seem counterintuitive to take on more debt in order to build up your credit, but the logic is that when you have more experience managing various loans, it shows lenders that you’re likely to be a good customer.
Tell me more about credit scores.
Your credit score is a rating meant to show lenders whether you can be trusted to repay your debts and helps them determine what cards and loan terms you qualify for. The most commonly used credit score is the FICO score, from the Fair Isaac Corporation. It ranges from 300 to 850, with scores between 670 and 739 being considered good (and 800 to 850 being exceptional). Another increasingly popular credit scores is the VantageScore, a relatively new rating developed by the three major credit bureaus (Equifax, Experian, and TransUnion).
You may be able to view your credit score and report for free through your bank or other financial institution. Discover provides the free service even if you’re not a customer. You can also view your score at no charge through certain financial sites, such as Credit Karma, Credit Sesame, Credit.com and Bankrate.
And how does credit mix affect my score?
Your credit mix, i.e. the different types of credit you use, is one of the five data categories that FICO uses to calculate your score. And the greater the mix, the better your score. So if you already have a student loan (reminder: that’s a type of installment loan), getting a credit card (a form of revolving credit) would help mix up your credit and could help boost your score.
Then again, credit mix only accounts for 10 percent of your FICO score. By comparison, three of the other five data categories—payment history (i.e. your record for making payments on time), amounts owed (how much of your available credit you use), and length of credit history—count for 35 percent, 30 percent and 15 percent of your score, respectively. (New credit, the fifth and final data category considered for your FICO score, also accounts for just 10 percent.) So if you’re afraid you can’t handle revolving credit very well, opening up an account just to improve your credit mix may not be worth it.
What’s the best way to use revolving credit?
Minimally. While it can be good to have open credit-card accounts, to both diversify your credit mix and give yourself a little credit cushion just in case, you want to use the accounts as little as possible. And however much you use, do your best to pay off the full balance every month. This responsible credit behavior does wonders for your credit score.
On the other hand, mismanaging your credit-card accounts can lead to big trouble. You can quickly wind up sinking your credit score and building up a mountain of debt that can block you from ever achieving financial independence. If you don’t think you can handle your credit well, you might be better off avoiding revolving credit completely—at least for now.
When you’re ready, maybe you can ease your way toward responsible credit-card ownership by taking on a secured credit card or a student credit card. Both act like credit cards on training wheels, with low limits and other restrictions to help minimize the damage you can do to your finances with them. That makes them great tools to practice using credit wisely while you build up your credit score.
Why is my credit score so important?
It can be the key to scoring useful financial opportunities. With a high credit score, you can qualify for new loans with low interest rates, high limits, and the best possible rewards. You can even use it as leverage in renegotiating better terms on your existing loans, which means a better shot at paying them off faster and freeing you up to make more money moves. Either way, building and maintaining an excellent credit history and score can give you a great boost toward successfully executing your overall long-term financial plan.
This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.