Photo (cc) by Philip Taylor PT
I recently got the following email from a reader who apparently wants to work on his credit score by adding additional types of credit to his credit history…
I am trying to diversify my credit by adding another form of credit other than credit cards to my portfolio. I don’t have a car or a home, so mortgage and auto loan are out. I was told adding an installment loan could help diversify my credit. I heard of a service called an “overdraft protection loan.” It acts as a loan for when you go negative on your checking account. This service is different from other forms of overdraft protection in that it’s reported on your credit as a loan and not like a credit card.
Now the only question is where? I called all the big banks and they don’t have overdraft protection loans, only lines of credit, or overdraft protection linked to a savings account. I decided to check with credit unions. I found one that has a product called an “overdraft protection loan”. When I went into the branch I sat down with a banker and he didn’t seem to know how it was reported on my credit. He said it is revolving so its like a line of credit. Then I called the credit union’s customer service number and spoke with a loan officer and she said the same thing. I don’t think they know.
If the product has the word loan in it, I would guess that would differentiate it from a line of credit. Any help with this? I think I know what I need, I just can’t find anywhere that understands what I need so they can tell me if they offer it.
Here’s your answer, Kevin!
You’re right that showing different types of credit can help with your credit score – but you may be overdoing it.
According to Fair Isaac, the company behind the most popular credit score, called the FICO score, here are the components that make up your credit score, along with their relative value:
- Payment history: 35 percent. This is essentially how well you’ve done repaying money you’ve borrowed.
- Amounts owed: 30 percent. This is about how much you owe in total and how much you owe relative to the amount you’re approved to borrow (also known as your utilization rate).
- Length of credit history: 15 percent. Self explanatory: how long you’ve been using credit.
- New credit: 10 percent. The number of new accounts, especially in proportion to all credit accounts.
- Types of credit used: 10 percent. This is what Kevin’s focusing on: the various types of accounts in your credit history, including credit cards, installment loans, mortgages, and consumer finance accounts.
The first thing to note is that adding various types of credit to Kevin’s credit history will affect only 10 percent of his credit score. So no matter how diversified he gets, it’s unlikely to move the needle much. That being said, however, it’s at least something he can do that could theoretically improve his score.
But looking for the word “loan” in the title of a banking product isn’t how to find an installment loan. All types of credit might use that word, including the type he already has. Instead, he needs to understand the types of credit.
Revolving credit: A maximum credit line is established, then the borrower draws from it in variable increments, pays it back in any amount – typically subject to minimum payments – then uses more or less of their available credit as they wish. So this is a loan that goes on indefinitely and whose payments vary with the amount used. Credit cards and home equity lines of credit are examples of this type of loan.
Installment credit: This normally begins with a lump-sum loan that is paid back (amortized) over a set period of time by making fixed, periodic (typically monthly) payments until the loan is fully repaid. So this is a loan that has specific payments, along with a starting date and ending date. The most common type of installment loans are car loans and home mortgages.
Secured credit: This is a loan secured by an asset, known as collateral: Car and home loans are examples.
Unsecured credit: Not secured by collateral: Credit cards are an example.
What’s available to Kevin?
Kevin already has unsecured, revolving credit in the form or credit cards, and he says he doesn’t to want secured credit. When he went to various banks asking for an overdraft protection loan, he was correctly told that these aren’t installment loans, they’re revolving loans: something he already has.
What’s left? Kevin needs an unsecured installment loan. He can go to a bank or credit union and take out what’s called a “signature” loan. It’s an installment loan, because it will be a lump sum, due in full by a certain date, which he’ll pay back in equal monthly installments.
The downside, of course, is that he’ll be paying interest for seemingly no other purpose than to add one additional credit source to his credit history. Worth it? I don’t know for sure, because Kevin didn’t mention his purpose. But frankly, I doubt it.