What is Credit, and Why Is It So Confusing?
The word credit can mean several different things depending on the context. So let’s break down all the ways credit can be used in a sentence:
- Credit is the amount of money you can borrow from a financial institution and the terms and conditions that are associated with it.
- Credit can also be used to refer to your creditworthiness or how easily you can get loans at lower interest rates. When used this way, a person is often described as having good or bad credit.
- Credit can also be used interchangeably with Credit Score. This is similar to creditworthiness, except that it can be quantified through FICO scores. When fintech apps say that they will help you build credit, they’re usually referring to this definition.
- Credit can also be defined as the opposite of debit. But this shouldn’t come up often unless you’re an accountant.
Why Does Credit Have So Many Meanings?
It would be easy to blame accountants since Luca Pacioli, the father of accounting, first used the word credit in double-entry accounting. However, the confusion surrounding the word is mostly the fault of linguistics.
The word credit comes from the Latin word creditum, which means loan. When the Roman Empire fell and modern-day Italy was born from its ashes, the word creditum turned into credito, which means trust in Italian.
So even way back then, credit could have referred to either a loan or creditworthiness.
Sure we could all agree to use the word in the way the Romans originally used it, but there’s a reason why Latin is a dead language. Languages either change or die, and words tend to take on new meanings when they change.
In the case of this article, we’ll be using the word credit to refer to the amount of money you can borrow from a financial institution and the terms and conditions that are associated with it.
What are the Four Main Types of Credit?
1. Installment Loans
Installment loans allow you to borrow a sum of money that you repay in installments over a set period of time. Examples of installment loans include:
- Buy Now, Pay Later (BNPL). BNPL often comes in the form of a 0% interest pay-in-four plan that’s paid in bi-weekly installments. The main difference between BNPL and other installment loans is that you often have to pay 25% of the product’s price upfront with BNPL. Some BNPL plans can also be paid in more than four installments. However, most of these plans charge interest rates of up to 36% APR.
- Mortgages. A mortgage is a long-term installment loan that’s secured by your house. By using your house as collateral, you can borrow an amount equal to its current value. Mortgages are usually paid in monthly installments over several years or even decades.
- Auto loans. An auto loan allows you to borrow an amount equal to the value of a vehicle that you want to purchase. This installment loan is then secured using the vehicle you purchased. Auto loans are often paid in monthly installments over several years.
- Student loans. Student loans, whether federal or private, are paid in installments. Student loans differ from other installment loans in that they can often be paused via forbearance or deferment. In fact, all federal student loans in the US have been paused for three years during the COVID-19 pandemic and were only recently unpaused on October 1, 2023.
2. Revolving Credit
Revolving credit often comes in the form of credit cards. It’s called revolving credit because you can make a partial payment and carry your debt over to the next billing cycle.
Credit cards are the most common example of revolving credit, but there are others, such as Home Equity Lines of Credit (HELOC) and Personal Lines of Credit (PLOC).
3. Open Credit / Charge Cards
Open credit often refers to charge cards that are similar to credit cards except for the revolving credit part. This means that charge cards require users to pay the full balance for each billing cycle.
This seems like a weird service in comparison to credit cards, but charge cards actually predate credit cards. You could say that credit cards are the natural evolution of charge cards. However, the advantage of open credit is that there’s no risk of financial overextension.
By paying all of your balance each month, there’s no risk of accumulating a debt that you have to pay cumulative interest on. However, open credit often comes with a hefty annual fee. In exchange, charge card users have high spending limits and relatively generous rewards.
4. Service Credit
Believe it or not, Experian now considers payment for services like electricity, natural gas, cable, internet, cellular, and other bills as a type of credit. Because if you think about it, these services can bill you daily if they want to. But they instead bill you monthly for the sake of convenience.
So effectively, each month, they extend you a line of credit equal to the bill that you pay in the following month – after the fact, meaning after the expenses have been incurred.
The only issue is that these service providers currently don’t furnish data to the credit bureaus, so your payment history with them is not recorded unless you use an app like Cushion or Experian Boost.
How the Different Types of Credit Impact Your Credit Score
Despite being different types of credit, all of them affect your credit score in the same way.
If you make your payments on time and your data is furnished to the credit bureaus, then your credit score will increase. And if you miss your payments, then your credit score will decrease regardless of the type of credit.
However, there are some credit score factors that only affect specific types of credit:
Credit Utilization and Lines of Credit (LOC)
Credit utilization is the amount of money you’ve borrowed in comparison to the total amount you can borrow. This means that credit utilization only applies to credit types that extend LOCs to borrowers (revolving credit & open credit).
By keeping your credit utilization at 30% or less, you can consistently increase your credit score. However, if you borrow more than 30% of your available credit or, worse, max out your credit card, then expect your credit score to take a hit.
Hard Credit Inquiries
Most credit cards and charge cards will pull your credit report from the credit bureaus upon your application. These instances are called hard credit inquiries, and they affect your credit score negatively if too many of them are made in a short period of time.
Most installment loan providers make hard inquiries as well with the exception of short-term BNPL loans and federal student loans.
Credit Mix
Credit mix is the different credit types you have in your credit report, and it makes up 10% of your FICO score. In general, utilizing a variety of credit types increases your credit score.
However, this is only true if you make your payments on time. And even then, it’s not advisable to apply for various financial services just for the sake of increasing your credit mix. The reason for this is the credit score factor mentioned above, which is hard inquiries.
Applying for too many loans will cause your credit report to be bombarded with hard inquiries. And hard inquiries stay on your credit report for two years. In general, it’s better to apply for the financial services that you need instead of applying for the sake of increasing your credit mix.
Frequently Asked Questions
What are the Four Types of Credit?
The four types of credit are Installment Loans, Revolving Credit, Open Credit, and Service Credit.
What is Secured Credit?
These are loans that have collateral. In other words, they are loans that require you to pledge something of value that the financial institution can seize in the event of a default.
How Do I Build Credit?
Building your credit is done by making your payments on time, utilizing 30% or less of your available credit, avoiding applying for too many loans in a short period of time, and ensuring your payment history is reported to the credit bureaus.
What is a Hard Inquiry?
Hard inquiries are the instances in which a financial institution pulled your credit report from the credit bureaus. They stay on your credit report for two years, and accumulating too many of them in a short period of time will decrease your credit score.
How Does Applying for Multiple Credit Accounts Affect My Credit Score?
Doing so will decrease your credit score due to the number of hard inquiries that will result from this.
What is a FICO score?
A FICO score is what most people refer to as your credit score and it’s a three-digit number that ranges from 300 to 850. This number is supposed to represent the summary of your credit reports from all three credit bureaus.
What Is a Line of Credit?
A Line of Credit is an agreement between you and a financial institution regarding the maximum amount of money you can borrow.
Conclusion
Revolving credit, open credit, installment loans, and service credit increase your credit score if you make your payment on time and if your payment history is reported to the credit bureaus.
Revolving credit and open credit also affect your credit score based on your credit utilization. While almost all credit types with the exception of short-term BNPL loans and federal student loans, will hit you with a hard inquiry upon application.
It’s also now possible to build your credit profile with your bills by paying them with the Cushion Card.
