If you’ve just started building your credit, it may feel like a catch-22: It’s tough to get credit without already having a good score, and you can’t get a good score without showing that you can handle credit.
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How do you deal with this conundrum? You start slowly, just like everyone else. There are two major types of loans: revolving lines of credit and installment loans. While both types are reflected in your FICO® Credit Score, you don’t have to obtain both types of loans in order to build a healthy credit history.
What’s the difference between revolving lines of credit and installment loans?
A revolving line of credit is a loan where credit is always available; you can keep borrowing on the condition that you’ve been repaying the debt according to the agreement you have with the creditor. A credit card is a classic example of a revolving line of credit.
Installment loans are not open-ended. You borrow money once and repay the principal and interest up until the point when the debt is completely paid off. Mortgages and auto loans are the most common examples of installment loans.
Is ‘Credit Mix” a key factor in my FICO® Credit Score?
While the FICO® Credit Score does take into account what kinds of loans you have under the category “Credit Mix,” this has a minimal bearing on your overall credit score. Ideally, you would be able to demonstrate how you can handle both types of loans, but, as you can see from the chart below, “Credit Mix” typically accounts for 10% of your score.
Two other components usually make up the majority of your FICO® Credit Score: your “Payment History” and “Amounts Owed.” Getting a credit card can have a positive effect on your credit score so long as you handle it responsibly.
Note: The chart above illustrates how significant each of these categories are and how they impact FICO® Scores for the general population.
Why not build credit with an installment loan instead of a credit card?
It’s a possibility, but there are a couple of hurdles. Getting an installment loan is more difficult in most cases, and it’s never free. A credit card, on the other hand, can be completely free if you choose a no-annual-fee card and pay it off every month. In addition, credit cards may offer added protection benefits and pay you cash back or other rewards.
Is one credit card enough to build credit?
A credit card, or rather your responsible handling of your finances, can help build a good score, but having only one credit card could be problematic. If you check the chart above, you will see that the second most important FICO® Score component, “Amounts Owed,” typically makes up 30% of your overall score. This component addresses your debt-to-credit ratio, or utilization rate. So if have only one card and use a lot of your credit, your score may be affected.
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How many credit cards do I need to build my credit?
The answer depends on your credit utilization and how much credit you need, so consider the ratio of how much you spend compared to how much credit is available to you on your card, or cards. Remember that you shouldn’t use all your available credit — just let it help you build up and maintain your score.