Read this before opening a credit line

By
Mortgage and Lending with First Option Mortgage 269761

Installment or Revolving –Which is better for your credit score?

 

Revolving Accounts, are used for Credit Cards to obtain money to buy merchandise or to get cash advances repeatedly, as long as there is money available to do the transactions. Once a Revolving Account is paid off, it can be used again up to (and sometimes over) the credit limit. There is no need to open a new account each time money is needed.

Aside from Revolving Accounts are Installment Loans.

Installment Accounts are used to finance things like cars, student loans, unsecured loans, furniture, mobile homes, medical expenses, airplanes, boats and so on.

In a perfect world we pay cash for everything or at least we use our Credit Cards to pay for things and then at the end of the month, we pay off the entire balance.

We don’t live in a perfect world.

Most people don’t have a credit profile when obtaining student loans, so they are forced to open a student loan to pay for school. These loans are installment loans. The student makes installment payments until the balance reaches zero. Once the balance reaches zero, the account closes. If the student wants more money, a new installment loan is opened and the process is repeated.

Most people won’t or can’t wait on saving money for a car, so they go to a bank, credit union or an auto dealership and obtain financing for a car. I always recommend going to a bank or credit union and getting a loan from them BEFORE going to the dealership. It forces the dealership to work with what you have. Once the car is paid off, the account closes. If the person wants to buy another car, a new loan is obtained.

Installment loans usually carry larger monthly payments than that of a Credit Card. Why? Because Installment loans are based on paying them off within a certain time frame. If you get a $30,000 loan and you are given 36 months to pay it off (with no interest), the monthly payment equals $833.33. A car dealership may instead offer the person a loan for 84 months to make the payments more affordable.

Credit Cards usually require a monthly payment of 1.5% of the balance due. That same $30,000 balance requires a $450 payment.

Each time a person opens a Credit Card account on the credit report, more than 15 points are subtracted from the person’s credit score. For each inquiry on the credit, 7 points are lost. Another 7 points are lost due to having a brand new account. More points may be deducted depending on the balance due versus the credit limit offered at the time the creditor reports the information to the credit bureau. Also, the type of credit (bank card vs financial services company) obtained can further deduct more points.

Sounds pretty damaging huh?

You ain’t seen nothin’ yet.

Although Installment loans make the most financial sense, they do more damage than a Credit Card.  The same amount of points are deducted, however with Installment loans, they are usually paid out for a certain amount of time.  In almost all cases, the account will start with a balance equal to the credit limit. Balances over 50% of the credit limit do the most damage to the score, whether a Revolving Account or Installment Loan. Why? Balance to credit limit equates to 30% of the score. As the person makes Installment payments and the principle balance reduces, the credit score increases. Because the monthly payments are significantly higher than that of a credit card, the borrower is less likely to pay down the balance quickly. This causes the balance to stay over 50% of the credit limit for a longer period of time further damaging the score for a longer period of time.

To close a credit card, either the creditor or the customer must close the account. With Installment loans, the customer can only close the account by paying off the account. The creditor can close the account but must continue collecting payments until the account is paid off. In other words, once the account is paid off, the customer cannot keep the account open or re-open it.

Every time an account closes on the credit report, points are lost. Why? The history length of a credit line accounts for 35% of the credit score. The older the account, the higher the score. A person who opens an Installment loan and then pays it off in 3 months is severely damaging his/her credit score.

The more activity given to a Credit Card with regards to positive usage, the higher the credit score climbs. The more activity given to an Installment loan with regards to positive payments, the closer you get to paying it off at which time the score lowers.

If you are forced to have to open an Installment loan for some reason, follow this rule: Request twice as much as you need. For example: I need $3,000 to fix my car. I’ll get the loan for $6000. Once I get the check for $6000, I’ll pay $3,000 of it back to the lender. The lower balance will be less than 50% of the credit limit (because I will have already made 1 payment by the time the balance reports to the bureau). This will reduce the negative impact of the installment loan with regard to balance to credit limit.

When it comes down to it, to maintain a good credit profile, you should have at least 5 Revolving Accounts and each should be open for at least 2 years. A zero balance should be maintained on the accounts and they should be used at least every 6 months. 

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Rainer
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Bill Polack

Bilingual Spanish Loan Officer in Southeast US.
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