About 10 percent of your score takes a look at the type of credit you have. This considers not only the mix of credit, but also the presence / lack of presence of harmful credit.
The Type of Credit You Have Component #1: The mix of credit.
Ideally, you should have:
- Between three and five major revolving credit cards (which include Visa, MasterCard, American Express, and Discover, but not retail store accounts).
- A mortgage.
- An installment loan (usually a car loan, but could also be a loan for a boat, piece of furniture, household appliance, or electronic equipment).
Most people know that having too much credit will hurt their score. After all, the credit-scoring models know that people with a ton of credit can easily become overextended. But what you might not know is that having too little credit will also hurt your score. The credit-scoring models need information about your ability to manage debt. Without this information, they have no ability to give you a credit score. Better safe than sorry, they think, and they assign you a low credit score.
Think of it like this: Let’s say you are scheduled to take an exam at 8 a.m. on Friday. You must pass the exam, or you will not be given a license to perform heart surgery. You oversleep, your child’s babysitter is late, and your car gets a flat. Needless to say, you miss the text. Do you think you will be certified to perform heart surgery? No way! Without the results of the test, the licensing boards will take the safe route.
Likewise, if you have not given the credit-scoring models any evidence as to your ability to manage credit responsibly, you will have a low credit score. You might even have a lower score than someone with a poor credit history. The credit-scoring models want to see that you have the discipline to manage debt and high limits. If you do not have credit, they have no evidence one way or another.
With this in mind, make sure you have:
- At least three major revolving accounts. If you do not have three, apply for secured credit cards (if your credit is poor) or non-secured credit cards (traditional credit cards reserved for people with good credit).
- An installment loan. Some people mistakenly believe this requires them to apply for a car loan. This is not true. Be sure to read our article about how to fix credit by adding an installment loan.
- When the time is right, your credit score will benefit even more by adding a mortgage. Of course, you should never buy a home just to increase your credit score. This is simply a note to say that paying a mortgage on time is one of the best things to happen to a credit score.
The Type of Credit You Have Component #2: The one type of credit you should always avoid.
One type of credit will always hurt your score. If you apply for a “buy now, pay nothing for six months” loan, your score will decrease. Accounts that allow you to delay payments for more than a month after purchasing an item are called finance accounts, and they will always hurt your score.
Finance accounts are often hard to detect. Perhaps they allow you to defer interest. Some allow you to pay interest only for a specific period of time. Most often, these loans are advertised by retail outlets that sell major household items:
- A sofa company announces that you can buy a couch today (October 11) and pay nothing until June.
- A mattress company has a huge sign that reads: “Sleep in a new bed tonight. Pay for it next year!”
These are often tricky to spot because they appear to be retail accounts. Retail accounts are store-specific credit cards that require payment every 30 days. Though I suggest that you never apply for retail credit cards, they do not hurt your credit score, so long as you manage them responsibly. Some retail accounts have billing cycles that are longer than 30 days, but these accounts are not considered finance accounts. Rather, they are revolving credit accounts that lengthen the billing cycle instead of delaying payments.
Like I said, finance accounts can be tricky to spot. A good rule of thumb to make sure you keep pesky finance accounts off your credit report is this: Always speak directly with bank representatives if you are ever in a store applying for a line of credit. The store representative most likely will not know the difference between a finance account and a retail account. Ask the bank representative directly to determine how the item will be reported to the credit bureaus, or refuse the account.
These accounts hurt your score for several reasons:
- Part of your credit score is determined by your balance-to-limit ratio, so your score could be negatively impacted by finance accounts because your balance will be 100 percent of your limit until you start making payments. Worse yet, as interest grows, it might be more than 100 percent your limit!
- These loans suggest that you are in a financial bind and cannot afford to make immediate payments. If you cannot make the payments now, the credit-scoring models will assume you will be unable to make them in the future.
Finance accounts are the only type of credit account that will hurt your score every time. For this reason, I suggest that you never apply for them, especially if you are planning on making a large purchase in the next few months.
Occasionally, you might be in a position where your credit can afford to take a hit. Let’s say that your credit score is 800, you have plenty of money in savings, and you have no intention of making a large purchase in the next few years. You set out to buy a new sofa, and you learn that you can purchase a sofa using an installment loan that does not begin to accrue interest for six months. Might it be wise to keep your money in savings, earn some interest, and pay the loan off in five-and-one-half months? Perhaps, but rest assured that your credit score will drop!
What makes up a credit score? Part I: Your payment history.
What makes up a credit score? Part II: Outstanding debt.
What makes up a credit score? Part III: The age of your credit.