Monitoring your credit score is a modern-day necessity. It impacts where you can live, what car you drive, and whether you can borrow money. There are many factors that contribute to that score and exactly how it is calculated is a closely guarded secret. But a lot of general information on the method exists for you to review.
While most people have a concept of ‘good’ and ‘bad’ debt, not everyone is sure where specific items fall in that spectrum.
Mortgages on houses tend to be good debt, but are car loans?
Credit cards tend to be bad debt, but what about personal loans? Here’s a general review of how your credit score is calculated, with emphasis on how unsecured debt, like an unsecured personal loan, affects it.
The most widely used score, from a company called FICO, ranges from 300 to 850. On the FICO scale, the higher the number, the better. In general, anything over 740 is considered excellent and will qualify you for the best rates: if your score is below 650, you’ll pay very high rates on loans and credit cards, if you qualify for them at all.
These break down the factors affecting your score into five categories, each one accounting for a percentage of the total score.
Here are the percentages:
- Credit Mix 10%
- New Credit Requests 10%
- Length of Credit History 15%
- Credit Utilization 30%
- Payment History 35%
Let’s dive into each of these to see how unsecured debt fits into this model.
Types: Installment versus Revolving
First thing to do is talk about what types of credit there are and how they fit into the category of credit mix. All credit can be divided into four boxes.
First let’s talk about installment versus revolving credit. Installment means the loan is for a specific amount of time, with a specific number of payments, each the same amount. Examples might be a mortgage, a car loan, or a personal loan. Revolving credit allows the borrower to use up to a certain limit and only pay interest on the amount used.
Repayment is not a fixed amount, but a minimum payment based on the amount owed. The borrower can pay off the entire amount, just the minimum, or anywhere in between.
The most common example is a credit card. The credit mix in your credit score gives you more points if you have both installment and revolving credit. If you only have one and get the other it will lower your score.
Types: Secured versus Unsecured
Security for a loan is also known as collateral. A secured loan uses something of value as collateral for the loan and the lender can claim it as repayment. With a mortgage, the lender can foreclose, starting a process to sell the house or property to pay off the loan.
With a car loan it’s known as repossession, and the lender can take the vehicle and sell it to clear the loan. An unsecured loan has nothing that the lender can claim to help pay back the loan. Typically, this results in a higher interest rate as the lender is taking on more risk.
While installment loans and revolving credit can each be secured or unsecured, the most common revolving credit is unsecured, like credit cards or lines of credit, and the most common installment loans are secured, like mortgages and car loans.
Personal loans for debt consolidation are one type of unsecured installment loan. Getting a consolidation loan to pay off credit card debt can shift your balance from revolving credit to having more installment credit.
Each time you apply for credit this request reduces your credit score slightly, although there are ‘soft’ inquiries that don’t have this effect. The impact is low unless you make many requests in a short time. Applying for an unsecured loan can lower your score.
Length of Credit History
The length of time you have had a loan or revolving account impacts your credit score. The longer the history the higher the credit score. Adding new debt with a short history will cause the time to be averaged and reduce it.
Keeping open old credit history to bring your average up is often a good idea. So check with an advisor before closing very old credit accounts that are paid off. Again, getting a new unsecured loan will drop your average and reduce your credit score.
Amounts Owed (Credit Utilization)
If things weren’t complicated enough, credit utilization would make up for it. The higher percentage of your available credit you use, over a certain threshold of about 30%, the more it lowers your credit score.
Exceeding your available credit, going over your limit, will impact your score even more. But the majority of this is calculated from revolving credit, where you have a limit and an amount borrowed to form this percentage.
Installment loans don’t impact this as much. So an unsecured credit card will have a large effect on credit utilization, while an unsecured personal loan will have a small one. And moving debt from a credit card to a consolidation loan will reduce your credit utilization and increase your credit score.
As you should have noticed from the formula, the biggest impact on your credit score is your payment history. Missing a payment or having a late payment will have a significant effect no matter if it is secured, unsecured, installment, or revolving.
This is why you must always make at least your minimum payment on your credit cards, and pay all your installment payments, mortgage, car payment, or other loans, on time every month.
These are your biggest factors that can drop your score quickly. And the higher your score was to start with, the more it will drop.
As you can see, The credit score calculation is complicated and assessing the impact of one type of debt can be difficult. Having both installment and revolving credit will help your score, but applying for new credit can hurt it and shorten your average credit history.
But if you get an unsecured installment loan to pay your unsecured revolving credit, it can improve your credit utilization percentage. And if you miss payments on any of these it can wipe out any of the improvements you’ve achieved in other ways.
Monitor your score regularly and plan any changes to your credit profile carefully. With close attention, you can improve your score and even help reduce your debt, but make a mistake and you could be worse off than when you started.
Be careful, be cautious, but most important, be credit savvy.