Installment Debt vs. Revolving DebtOctober 3, 2021
You’ve probably heard that your credit score is an important part of determining your financial health. Your credit score is made up of several factors with varying levels of importance. The type of debt you have is one of the factors involved in determining your credit score.
There are two main types of debt, revolving debt and installment debt. Let’s take a look at revolving debt vs. installment debt and how they can impact your credit score.
Revolving debt vs. installment debt
So, what is revolving debt? What is installment debt? Both types of debt are used as part of the formula that makes up your FICO credit score. It’s the most-used scoring model, and 10% of your score is based on your credit mix, which includes whether you have revolving or installment accounts. Let’s take a closer look.
What is revolving debt?
Revolving debt is a type of debt where you have a maximum credit line. You can keep borrowing until you reach that credit limit. As you make payments, you “free” up more room to use the credit line. With revolving debt, you don’t have to re-apply for funds later. Types of revolving debt include:
- Credit cards
- Home equity lines of credit (HELOCs)
- Credit lines offered by banks
What is installment debt?
Rather than an ongoing credit line, installment debt is usually delivered to you in a lump sum. You make regular payments to discharge the debt over time. If you want access to funding again, you have to re-apply. Some examples of installment debt include:
- Car loans
- Student loans
- Home mortgages
- Personal loans
Revolving debt vs. installment debt: how do they impact your credit score?
While both revolving and installment debt are considered in your credit mix, how you manage your debt is another aspect of your credit score.
The most important aspect of your credit score is your payment history, which affects 35% of your FICO score. When you miss a payment, or you pay late, it will show up on your credit report and impact your score.
However, with installment debt, especially larger loans like a mortgage, missing a payment is likely to have a bigger impact on your payment history than being late on your credit card payment. The algorithm used by FICO is proprietary, but subtle weight is given to different types of debt, and the consequences associated with them vary.
Where revolving credit makes a bigger difference to your FICO score is in the area of credit utilization. Credit utilization is represented by a percentage of available credit you’re using on your revolving debt. For example, if you have a credit card with a limit of $5,000 and you have a balance of $2,500, your credit utilization is 50%.
Credit utilization matters because it accounts for about 30% of your FICO score. A general rule of thumb is to try to keep your credit utilization below 30% on your revolving lines of credit if you don’t want your revolving debt to have a bigger negative impact on your overall FICO score.
Age of your credit
Another factor included in your credit score, accounting for about 15% of your FICO score, is the length of your credit history. The longer you have accounts open, the better your credit score. Because installment loans are designed to be paid off over time, paying attention to revolving credit can be a good way to boost the average length of your credit history. It’s also one reason that some experts suggest that you avoid closing your credit cards when you pay them off, and instead put them where you won’t be tempted to overspend.
What is a revolving debt good for?
Revolving debt can be good for accessing funds for short-term expenses or ongoing costs. For example, a HELOC can be used for home improvement projects, letting you draw on the money as you need it, rather than having to apply for a new loan.
Credit cards are also very useful when it comes to establishing a credit score quickly. Because credit card payments and utilization are reported each month, small purchases can be made and paid off, providing a quick way to establish and build credit. However, it’s important to be careful not to spend more than you can afford since credit card interest rates can be high and cost you much more in the long run.
When deciding which type of debt to tackle first, it’s often a good idea to start with revolving credit. If you can lower your credit utilization, it will boost your FICO score, plus help you save on interest.
What is installment debt good for?
On the other hand, installment debt is often used for larger purchases, making them more affordable over time. For example, if you can’t afford to pay $10,000 or $15,000 for a car, an installment loan can make it more affordable. The same is true of schooling. Higher education can potentially help you earn more money, but few people can pay the tuition bill upfront. A low-interest student loan can potentially help you cover the cost and make manageable payments later.
However, it’s important to be realistic about what you can afford to pay each month, and to be careful not to borrow too much — you still have to pay it back later.
Understanding how debt can be used in your life is an important part of long-term financial planning. However, you also need to be careful. Whether it’s revolving debt or installment debt, make sure you have a plan to repay it as soon as possible.