Why Only Using Credit Cards to Build Credit is Not Enough

Written By Will Lipovsky 

A common piece of ‘advice’ offered by well-meaning laypersons is, “Use your credit cards responsibly and your credit score will be good.” Is this true? Is this really all it takes to obtain a glowing credit history?

This topic is quite important. A lot is riding on a person's credit history. Insurance rates are often affected by a person’s credit history. Renting an apartment is often more difficult with a low score or no score. Employment opportunities are even affected. On a more personal level, a person's self-esteem can be negatively impacted by a low score. With all of this on the line, it’s important to understand how a person can build credit quickly and wisely. It’s important to get the facts about how a person can attain the best credit score possible.

What makes up a credit score? A credit score is made up of five factors: payment history (35% of overall score), amounts owed (30%), length of credit history (15%), types of credit used (10%) and new credit (10%). This reveals that 10% of a person’s credit rating is based on credit mix. What’s in the mix?

The two main types of loans that go into this mix are referred to as revolving loans and installment loans. Revolving loans are typically credit cards. Installment loans are loans that carry more responsibility. Examples of these are auto loans, mortgages and credit building loans.

It’s important to get both revolving loans and installment loans. Skipping out on installment loans entirely would mean 10% of a credit check would be unimpressive. After all, there would be no mix. Hoping that the use of credit cards alone is enough to build credit is like hoping diet will be enough to build muscle. It will help, certainly. Our muscles need protein and nutrients. But in order to make a real difference, we must focus on diet and exercise.

Think of it in another way. How wise would it be to neglect 10% of a college exam? Not wise at all.

Joseph Hogue, CFA and founder of PeerFinance101.com agrees: “Type of credit used is 10% of your credit score so too much revolving credit, as opposed to non-revolving, will drag your score down.”

Though before taking out any type of loan, it’s first best to understand your current situation. John Rampton, founder of Due.com, shares his story: “One of the fastest ways to build credit that most people don’t talk about is knowing why your credit is low in the first place. I did a full credit check a year back and found two unpaid bills. These had been sent to an old address of mine and then went to collections. Both together totaled less than $300. I paid these off and sent a letter to have them report them. I then sent an official letter to have those records removed. Next thing I knew my credit jumped 50 points”

Now, in order to get the proper mix of loans, a few things must happen. Don’t worry - they are far from painful and even farther from expensive. Neither require sketchy Payday lenders, either. The first thing most people consider is to get a credit card.

Getting a credit card with no credit history or limited credit history is possible. Students should consider getting a student credit card. The odds of being approved for these cards are high.

Secured credit cards can also be considered. It sounds odd but secured cards are actually easier to get than unsecured cards. That’s because secured cards require prepayment. For instance, if the applicant gets approved for a $500 line of credit, that person can deposit $500 with the credit card company in exchange for the $500 in credit. When selecting a secured card, make sure the company reports card activity to all three credit bureaus. This is how your score will increase.

It’s now time to consider the other part of the 10% mix - installment loans. As Eric Rosenberg, former banker and founder of PersonalProfitability.com, points out: “Revolving credit accounts do help bring up your credit score, but if you are looking to get a mortgage or car loan in the future, the best way to prove to a lender that you are responsible with that type of loan is an installment loan.”

Installment loans are an opportunity to build trust. Installment loans have fixed monthly payment amounts and fixed monthly term lengths. They can help you build payment history. A good example of an installment loan is a credit builder loan. 

A credit builder loan can help you improve your score in other ways than just payment history. Keep in mind the other parts of a credit score besides payment history: Amounts owed (30%), length of credit history (15%), new credit (10%), and types of credit used (10%). By using a credit builder loan you are increasing "amounts owed" and diversifying "types of credit used." 

To wrap up, a credit score is the closest thing we have to a financial test score. It’s a number that affects many areas of life such as securing employment, buying a car, buying a home and more. Luckily enough, we know what is taken into account when building a solid credit history and can use that knowledge to our advantage.

Having credit cards is wise. Handling them responsibly is wise. But if an optimum credit score is what you’re after, installment loans must be considered. The best way to get an installment loan is by getting a credit builder loan. This is where Self Lender can help.

Written on March 24, 2016

Self Lender is a venture-backed startup that helps people build credit and savings. Comments? Questions? Send us a note at hello@selflender.com.

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