Your credit score measures how well you've handled borrowed money, and lenders use it to determine how much of a risk it would be to let you borrow their money. Handle a loan responsibly, and it should help your credit score. But not all loans have the same effect on your score. In fact, the loans that have the biggest potential to get you into trouble also have the biggest potential to boost your credit score.
Types of loans
There are many types of loans, but for this discussion we'll focus on two broad categories.
Installment loans such as mortgages, car loans, student loans and personal loans. With an installment loan, the lender decides how much you can borrow and how much you need to pay back each month. You generally can't borrow additional money on the same loan, and you have little flexibility in payments.
Revolving loans like credit cards and home equity lines of credit. With revolving loans, the lender decides on the size of your credit line, but you decide how much of it you will use. You choose how much to borrow, when to borrow it and how much to repay at any given time — as long as you make a minimum payment each month. You can borrow money on the credit line, pay it off and borrow again as many times as you want.
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Greater freedom, greater influence
When lenders look at your credit history and your credit score, they're trying to predict how well you will handle new credit if they extend it to you.
Installment loans demonstrate that another lender found you creditworthy in the past and that you can make payments on time. That certainly helps build your credit history.
Revolving accounts such as credit cards provide even more information. Because credit cards give you flexibility to borrow, repay and borrow again, they demonstrate your credit-handling skills more effectively. That makes them a better predictor of how you will handle credit in the future, says Rod Griffin, director of public education at Experian.
With a credit card, "you’re exercising free will," Griffin says. "It gives a little more weight to scores because it’s more predictive of how you make individual credit decisions."
The risk with using revolving loans is that they generally have higher interest rates than installment loans. If your balance climbs too high, it can be hard to pay down the debt because more of your monthly payment is going toward interest than to reducing what you owe. Using a credit card responsibly and avoiding getting in over your head shows lenders that you can be trusted with additional loans.
» MORE: How to build credit
Can you build credit without a credit card?
There's no rule that says you must have a credit card to have good credit, and you certainly don't need to carry a balance on a credit card once you get it. But a revolving account can help future lenders see your full potential as a borrower.
Griffin lays out a simple formula for building credit with a credit card.
"If you can obtain a credit card — one credit card, maybe two — make a small purchase, pay it in full each month. It will help build that credit history and establish credit a bit faster,” he says.
For many, getting approved for a credit card is easier said than done. If you have bad credit or no credit, a good strategy is to start with a secured credit card, which requires a security deposit. But it's not enough just to get the card and stick it in your wallet. To fully show lenders that you're capable of handling flexible credit accounts, you have to use it regularly and make your payments on time.
"It’s not that you can’t have great credit scores with just installment loans," Griffin says. "It's just that a credit card ... gets you there a little bit faster.”
