J20) What are the four types of credit?
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Today We Will Talk About the What are the four types of credit?
Installment credit is a type of loan in which you borrow one lump sum and repay it with interest in regular fixed payments, or installments, over a certain amount of time. Once an installment credit loan is paid off in its entirety, the account is considered closed. Examples of installment credit accounts include mortgages, auto loans, personal loans, and student loans.Revolving credit accounts allow you to repeatedly borrow and repay amounts from a single line of credit up to a maximum limit. You’re in control over how much you borrow (and ultimately need to pay back). Interest is charged on any balance remaining after each statement’s due date, so it’s possible to avoid ever paying interest if you pay your balance in full each month. As long as you make all your payments on time, the account will remain open indefinitely until you choose to close it. Credit cards are the most common type of revolving credit, but HELOC (home equity line of credit) is another exampleOpen credit is unique in that monthly payments vary, and balances are due in full at the end of each billing cycle. Your electricity bill is a great example of open credit; the amount due depends on how much electricity you used that month. You’re expected to pay the entire bill within a certain number of days after receiving it. Many utility bills — such as gas, electricity, water, cable, and cell service – are considered open credit accounts.Having different types of credit is an important part of your credit score as it shows lenders you can manage various types of debt responsibly. However, it’s not always clear how many accounts you need from each credit type in order to demonstrate the right mix.
“Consumers of any age and just about any income level can build their credit to a level most lenders consider ‘good’ with just two or three accounts,” such as credit card, car loan, or student loan, says Todd Christensen, education manager at Money Fit by DRS, a nonprofit debt relief organization. According to Christensen, results can come fairly quickly — “within a year or two so long as they make their payments on time, keep their card balances at $0, and pay down their installment loan balances as quickly as they can.”
What is credit? art-credit-cards-620x349
Credit is defined in a couple of ways. One is the amount of money you are approved to borrow from a lending institution. With this approval comes an agreement to repay the charges, any additional fees that can or will be applied, and to abide by time restrictions.
Credit can also be classified as your borrowing reputation. It paints a picture of your payment history and provides the lender with information regarding the likelihood of your repayment, in other words, your risk factor.
Use of Credit
When used responsibly, credit can be a convenient and effective financial tool. From a simple credit card to an auto or home loan, credit is the American way of life. Cashless transactions are soon becoming the way of the future, and credit cards are among the most prevalent. Understanding credit is important in order to use credit to your advantage and to prevent the common financial pitfall – debt.
Four Common Forms of Credit
Revolving Credit
This form of credit allows you to borrow money up to a certain amount. The lending institution sets a credit limit, or the most you can borrow. In revolving credit, the borrower revolves the balance by rolling from month to month until it is paid in full. Interest charges typically occur for any revolving balance. As the money is paid back, the difference between the maximum credit limit and the current balance is available to be borrowed. This is the most common form of credit issued by credit cards, such as Visa, MasterCard, and store and gas cards. Credit cards are considered unsecure credit because there is no collateral securing the amount borrowed.
Charge Cards
This form of credit is often mistaken to be the same as a revolving credit card. However, the major difference between a credit card and a charge card is the credit card can carry a balance, whereas the charge card must be paid in full each month. If the balance is not paid on time and in full, penalty fees will be added. American Express is an example of a well-known charge card. This form of credit is advantageous against accumulating credit card debt.
Installment Credit
Installment credit involves a set amount borrowed, a set monthly payment and a set timeframe of repayment. Interest charges are pre-determined and calculated into the set monthly payments. Common forms of installment credit agreements are home mortgages and auto loans.
Installment credit is also typically secure. Secure credit requires security for the lender. The borrower must provide collateral, something of value pledge in order to guarantee loan repayment. If the borrower fails to repay, or defaults on the loan, the lender may confiscate the collateral. A home is an example of collateral on a mortgage, and a vehicle on an auto loan. If the borrower were to default, the home or vehicle would be repossessed.
Non-Installment or Service Credit
This form of credit allows the borrower to pay for a service, membership, etc. at a later date. Generally, payment is due the month following the service, and unpaid balances will incur a fee, interest, and/or penalty charges. Continued non-payment will result in service cancellation and can be reported to the credit bureau, affecting your credit score. Service or non-installment agreements are very common in our everyday life. Cell phone, gas and electricity, water and garbage are all examples of service credit.
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The three main types of credit are revolving credit, installment, and open credit. Credit enables people to purchase goods or services using borrowed money. The lender expects to receive the payment back with extra money (called interest) after a certain amount of time.
Revolving Credit
A line of credit is one type of credit that comes with a capped limit and can be used up until you reach the predetermined threshold. It may include regular minimum payments, but usually, there is not a fixed repayment schedule. An example would be a credit card as there is a capped limit (the credit card limit), and you can keep using it until you reach such a limit (then over-limit fees apply). Another example would be a HELOC (Home Equity Line of Credit).
Installment
Installment loans are another type of credit that includes a fixed payment schedule for a specified duration. An example of an installment loan would be a car loan — you are required to pay a set amount of money at a recurring interval (ex. $280 per month) until the loan is paid off in full. Other examples include mortgages, student loans, and term loans.
Open Credit
Open credit is a type of credit that requires full payment for each period, such as per month. You can borrow up to a maximum amount, similar to a credit card limit, but you are required to pay the funds borrowed in full at the end of each period. An example of this would be a cellphone bill — you can make phone calls, send text messages, and use data each month, and at the end of the month, you are required to pay for the services you used (including any additional usage fees). Another example would be a utility bill (such as electricity usage in your household).
Questions
Determine which type of credit the following statements refer to.
Q1) Each month, you are required to pay $300 until the loan is paid off in full.
Q2) You are able to borrow up to $2,000 per month but must pay for all the funds borrowed each month.
Q3) You can borrow up to $1,500 per month, but you are only required to make a minimum payment (paying off the loan in full is not required).
Answers
A1) Installment
A2) Open Credit
A3) Revolving Credit
Additional Resources
CFI is the official provider of the Financial Modeling Valuation Analyst (FMVA)®. Here are some additional resources you might find interesting:
Fundamentals of Credit Course
Consumer Loan
Credit Risk
Credit Administration
When it comes to your credit score, not all debt is treated equally.
Credit accounts come in many forms: credit cards, mortgages, auto loans, and student loans, to name a few. But did you know all of them can be classified into three distinct types of credit? Lenders look for evidence of each of these credit types in your credit report as proof you can manage various types of debt responsibly.
Having different forms of credit can boost your credit score — and lacking a good mix can hurt it. Here are differences between the three types of credit and how to use each to build a better credit score.
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