Having credit is an inevitable part of life as a consumer in the U.S. Millions of individuals have more than one type of credit account in their name at any given time, including credit cards, car loans, a mortgage, and student debt. The ability to borrow from a lender to cover major expenses is often a must, and maintaining a healthy credit history with different types of credit accounts is an integral factor in getting more access to credit in the future. To ensure your credit profile is strong, it is beneficial to understand the different types of credit available and when they can and should be used.
Types of Credit
There are only four broad categories of credit available to individual consumers, although each type has a handful of options for specific uses. The common credit types include:
Secured debt: With a secured credit account, a lender puts a lien on an asset owned by the borrower. A mortgage is a secured debt, as it an auto loan or a car title loan. Credit cards may also be secured with a checking or savings account. When a credit account is secured with an asset, the lender has the rights to claim that asset as their own should the borrower fail to repay per the account agreement.
Unsecured debt: An unsecured debt is any credit account offered to a borrower where no asset is used to back up the loan or account. A credit card is the most common example of unsecured debt, but a personal loan or a line of credit may also be unsecured. Because lenders take on more risk with unsecured credit accounts, borrowers may pay higher interest rates or have shorter repayment terms than when a debt is secured.
Revolving debt: Revolving debt is a credit account that does not have a set repayment schedule or borrowed amount. Instead, the account works as a reusable line of credit, like a home equity credit line or a credit card. Borrowers can utilize a revolving credit account up to the agreed upon credit limit, and pay whatever amount they feel comfortable with each month (so long as the minimum payment amount is met). Revolving credit accounts can be either secured or unsecured.
Installment debt: Unlike revolving debt, installment credit accounts come with a set amount borrowed as well as a set repayment schedule. A conventional mortgage loan, an auto loan, or a personal loan are all examples of installment debt. The borrower and lender come to an agreement regarding the terms of the debt, when payments will be due, and in what amount. Like revolving credit accounts, installment debt may be secured or unsecured.
When to Use Them
Individuals face the need to use credit accounts for a variety of reasons, but there are general rules of thumb about when to use which type of debt for most circumstances. When a borrower has less than ideal credit history, a secured credit account is often the path of least resistance. Because creditors can take ownership of the asset used to back the debt, strong credit history is not always necessary. For borrowers who have outstanding credit, unsecured debt may be a better choice. Individuals who have an ongoing need for access to credit should consider a revolving credit account, while those with a fixed, one-time need may be better served with installment debt. Each credit type has its advantages and drawbacks which should be considered before establishing a new account.