Do you want good credit? Responsible use of one loan can get you there. But if you want the highest FICO score—the one that gives you the best rates, the highest limits, and the best deals—you might have to mix things up a bit.
This is because FICO says that having a variety of loans is essential to maximizing your credit score. If you don’t have several different types of loans, this won’t kill your score. In the end, the “types of credit” component is the least important of the five factors in the FICO formula. But if you’re striving for excellence, a good mix of credits can push you to the top of the range.
What is a set of credits and how does it affect your score?
Your credit mix is about 10 percent of your FICO score. The term “credit mix” refers to the different types of credit accounts you hold: open, credit, revolving, and installment. Loan composition carries slightly more weight in VantageScore, where it, combined with your loan age, makes up 20 percent of your score.
Getting high FICO scores can save consumers money and time. Those with high FICO scores can enjoy lower interest rates and a higher chance of loan approval. To calculate your score, which ranges from 300 for bad credit borrowers to 850 for perfect credit borrowers, FICO takes into account five different factors. These include:
- Your payment history
- How much debt do you have (loan drawdown)
- Length of your credit history
- How much new credit do you have
- What type of loan did you use
At the bottom of this list, your credit balance is about 10 percent of a consumer’s FICO score. It has the same weight as the new credit category, which shows how many loans you have received or applied for in recent months. But in fact, these two categories are not quite equal.
“For the most part, it can be considered the least important of the five main components,” said Barry Paperno, a credit scoring expert who has worked for FICO and Experian.
Having different types of debt is not the strongest indicator of whether a consumer will repay loans, according to the FICO study, but it is useful.
“The FICO study found that, all other things being equal, consumers who have a “mix” of loan types on their credit reports tend to be less risky than those who have experience with only one type of loan,” Paperno said.
What types of loans does FICO consider?
The FICO scoring formula takes into account both the number and variety of accounts listed on a borrower’s credit report. “The number of accounts of each type is not as important to assessing a person as simply having experience with both types of accounts, either currently or in the recent past,” Paperno said.
For example, credit reports from three major credit bureaus might include the following:
- Installment loans, including auto loans, student loans and furniture purchases
- Mortgage loans
- Credit cards
- Unpaid loans taken by collection agencies or debt buyers
- Rent and utility data
Utility bills and charge cards are examples of open accounts, which means they must be paid in full each month and the amount varies. Mortgage or car loans are examples of installment bills that require a fixed amount to be paid in full each month.
A credit card account, on the other hand, is a revolving account, a line of credit that you have access to without a fixed monthly payment. Your balance determines the minimum payment and there is no set end date in your agreement.
A credit set matters to lenders because making a fixed payment each month is harder than varying payments to suit your financial situation. Your ability to meet your fixed monthly payments is evidence to lenders that you are a reliable borrower.
FICO accounts for all of these types of accounts in its credit scoring model, even timely rental payments if they are reported to the credit bureau. FICO has touted the usefulness of alternative data such as rent and utility bill payments for scoring consumers with thin credit files. In 2015, the company introduced FICO XD, a new credit scoring model based on alternative data.
What is a good credit mix?
You probably already have various types of open and revolving loans. But paying off an installment account, like a mortgage or car loan, also counts in your favor. What if you don’t have a home and paid for the car in cash? Do you need to apply for various loans and credit cards in order to build up your FICO score? Not exactly, experts say.
Along with the initial drop in FICO score that can occur when a lender reviews your creditworthiness – a so-called due diligence – there is a danger that you will not be able to handle this loan responsibly. This can lead to big problems in the future.
“Opening too many new accounts in a short period of time can be a sign of financial hardship for lenders,” said Rod Griffin, senior director of community education at Experian. “If you don’t have an installment loan, you may want to consider applying for a small loan to demonstrate that you can manage it well.”
Remember that the combination of credits is only 10% of your FICO score. This is not a credit deal breaker. But it is worth noting that taking out loans in the long run can be beneficial. The next time you have to buy a car, remember that the loan you take out will help, not hurt your credit history, as long as you make monthly payments on time.
bottom line
Instead of applying for a loan in an attempt to improve your score, it makes sense to channel your energies into the basics of FICO instead. Since FICO says that a good result depends more on paying your bills on time, focus on keeping your credit card balance low and opening new accounts only when necessary. Most borrowers have no reason to actively seek out a loan combination.
For consumers looking at their credit combinations, Paperno said, “It’s best to think of this category as more of a ‘good to know’ than a ‘need to know’ for a good FICO score.”
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