What if taking some money now meant you couldn’t take any money in the future?
No, we’re not talking riddles here. The truth is that accruing debt in different ways can have unexpected effects on your credit history, and this can jeopardize your ability to borrow money in the future.
Your basic choices when you need extra money are to use credit cards or to use installment loans. But which debt is actually worse for your credit history?
Keep reading to discover the answer to this complex question!
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What Are Installment Loans?
Before we can compare credit cards and the best online installment loans, it’s important that you understand what each of these is and how it works. Let’s start with installment loans.
Depending on your borrowing history, “installment loan” may be an unfamiliar term. This causes some borrowers to imagine that an “installment loan” is some special kind of loan.
It’s actually quite the opposite. “Installment loan” is a catch-all term for any loan that you must pay back in regular installments.
Most loans fall under this umbrella. One exception to this is payday loans, as many of those are designed to be paid back (with interest) within a single payment.
If you have ever had a loan for an automobile or if you have a mortgage, then you understand how installment loans work. And like any other form of borrowing money, installment loans have the potential to impact your credit in a number of ways.
For borrowers who need a smaller amount of money than is required for a car or a house, it can be tough to decide between getting an installment loan or getting a credit card.
Types of Credit Cards
Unlike installment loans, most people know what credit cards are and how they work. The idea is simple: you can spend money as credit up to a pre-approved amount, but you must pay everything back, with the debt accruing interest as time goes on.
Some consumers, however, are not aware of the different kinds of credit cards and how these might uniquely affect a person’s credit score.
The first type of credit card is a rewards card. These are cards that offer cash back or some other kind of incentive. To make the most of these cards, you must pay off the balance every month, which is actually great for your credit.
Other cards advertise themselves as low-interest credit cards. Such cards are explicitly aimed at people who will not pay the amount back at the end of the month. Low interest is an attractive idea for those who carry a balance each month.
Of course, interest rates can change on credit cards. That’s why balance transfer cards exist, as they allow you to transfer a balance from a high-interest card to a lower-interest card. And balance transfer cards sometimes offer zero interest for a certain amount of months, making it easier to pay them off.
Finally, there are secured credit cards. These are actually meant for people with bad credit, and they must be “secured” with some form of collateral (like money in your bank account). The amount of credit is typically lower on these cards, and cardholders use it in small doses to rebuild credit.
What Is Installment Credit?
Now that you know more about installment loans and credit cards, it’s important to learn more about the vocabulary of the credit world. And the next term is “installment credit.”
As you might imagine, “installment credit” is what you get from installment loans. It involves you being approved for a very specific amount, receiving that specific amount, and then paying that debt back in regular installments.
Like we said earlier, this type of credit can range from a very small personal loan all the way up to the mortgage on your house. All of these loans follow the model of you being approved for a specific amount and being given a schedule of regular payments to fully pay the loan off.
What Is Revolving Credit?
If installment loans have installment credit, then what do credit cards have? They have something referred to as “revolving credit.”
Unlike “installment credit,” the term “revolving credit” is sometimes confusing to consumers. To understand this means understanding more about credit cards themselves.
First, credit cards do not give you a specific amount like loans do. You have a maximum amount you are able to borrow at one time, but you’re in control of whether you get the minimum amount of whether you max the card out (which is rarely a good idea).
So, why is this credit “revolving?” It’s because the model encourages you to borrow money each month. Whether you are paying the full balance each month or simply making minimum payments, the credit card companies count on you returning time and time again to borrow more.
And that’s the main idea behind minimum payments as well. Whereas loans give you a very specific schedule to pay off a loan, credit cards allow you to make minimum payments towards debt.
However, when these minimum payments interact with your interest rate, it can actually take years to pay off even small amounts of credit that you have borrowed.
What Is Your Credit Score?
We’re here to determine which kind of debt is worse for you. And by “worse,” we mean which is worse for your credit score. However, “credit score” is another concept that many customers have heard of but do not know how it works.
Your credit score is a number that ranges between 300 and 850. This number is supposed to give lenders a good idea at whether they can trust you enough to loan you large amounts of money.
There are three major credit bureaus that determine your credit score. This includes Experian, TransUnion, and Equifax. There are sometimes differences between your score as reported by these different bureaus.
As you might imagine, it’s good to have the highest credit score that you can get. This opens a number of opportunities for you, and it can even help you avoid accruing more debt than is necessary.
This is because individuals with higher credit scores are typically offered better interest rates on loans and credit cards. Other individuals may be able to get cards or loans, but the interest rate is much higher.
If you don’t pay everything off very quickly, the interest rate ensures that your debt will just keep piling up!
How Is Your Credit Score Determined?
We talked about the three different credit bureaus and how they determine what your credit score is. However, that leaves a big question: just how is your credit score determined?
It’s actually more complex than you might think. These bureaus look at five different major factors, though some are more important than others.
The first factor is your payment history. This is the biggest factor in your credit calculation, and it looks at whether you have repaid things like credit cards and loans back in a timely manner.
Things like late payments and missing payments really lower the score because they make you seem less trustworthy when it comes to borrowing money in the future!
The next big factor is your debt usage. It’s okay if you have a small amount of debt (to be on the safe side, don’t borrow more than 30% of your available balance), but large amounts make installment loans direct lenders worry that you have too much old debt to take on any new debt.
The next factor is surprising to some: how long your credit accounts have been active. This is why many people advise you to keep old lines of credit active, even if you’re not using them. If you’ve had a credit card for many years and are in good standing with that lender, you’ll look trustworthy to a new lender.
A smaller factor they look at is your mix of credit types. This means they’ll look at your revolving credit and debt. It’s actually good to have a bit of both, so long as you’ve been making timely payments.
The final factor is simply how often you apply for credit. Unfortunately, every application for new credit creates a small “ding” in your score. Such dings are temporary, though, and this is mostly a factor so lenders can know if you’ve applied for a ton of new credit very recently.
Installment Loans vs. Credit Cards: Which Debt Is Worse?
Now that you know what these different factors are, we come to the big question. Which debt is worse to have?
The short answer is that credit card debt is worse than installment loan debt. This is true for several different reasons.
First, your credit bureaus pay more attention to your use of a credit card balance than loan amounts. Thus, using more than 30% of a credit card balance can do more damage to your credit than taking out a big loan such as a mortgage.
It’s also easier to get installment loan debt under control more quickly. You have a specific schedule of payments from the lender, whereas credit card companies have a vested interest in keeping your balance high. That’s why they offer minimum payments!
And focusing on credit card debt is usually more practical. These cards often have higher interest rates than your loans, so paying them down quicker will save you money even as it gives your credit history a boost.
Finally, don’t forget that installment loans may offer tax benefits that credit cards don’t. There are potential write-offs you can get from your mortgage that you can’t get from credit cards, so you should always pay those cards off first.
Ways to Pay down Debt
We have focused a lot on the benefits of paying down debt. However, many consumers don’t know the best way to start handling their debts.
The first step is to focus on one credit card at a time. If you have extra money to spend, don’t spread it across multiple cards: try to knock out one balance at a time.
Once you have paid off one card, you can take the amount you previously paid on that card and put it towards a new card.
It probably goes without saying, but you’ll need to pay more than the minimum amount that is due. Otherwise, paying off the card will take years, and you’ll pay a ton of interest.
Feel free to take advantage of balance transfer credit offers. Getting a lower interest rate is always good, and if you get six months or so of zero interest, you can really put a dent in your debt.
Finally, start looking at your monthly budget. Use an app to keep track of how much you spend on various things. Cutting back certain spending can free extra money up for paying down credit cards.
Ways to Rebuild Credit
If you’ve discovered you have bad or simple average credit, it’s good to focus on building it up. And you can do this every month.
Sign up for a free credit monitoring serving. This will provide monthly updates on your credit score and ideas on how to improve it.
If you’ve fallen behind on any payments, contact the lenders ASAP. You can work out payment arrangements with them that won’t negatively impact your credit score.
Be sure to pay all bills on time. Take advantage of any automatic payment services that are offered by your lenders and even your bank.
And if you’ve been focusing on paying down debt, we’ve got some good news! In addition to lowering what you owe each month, this is one of the best ways to boost your credit.
The Bottom Line
Now you know why credit card debt is worse than debt from installment loans. But do you know how to consolidate your debt?
At Bonsai Finance, we are the final authority in financial solutions. We offer a full range of credit cards and installment loans, and we also have unique solutions for bringing your debt down to size.
To see how we can help, check out our debt consolidation services today!