Understanding the Different Types of Credit
We all know credit cards, but did you know there are four different types of credit? I’m not kidding. In this article, we’ll look at each of them and how mortgage lenders treat them.
An instalment loan is likely what comes to mind first when you think of borrowing money. An instalment or personal loan is a loan for a pre-agreed upon amount over a set of time. For example, you may borrow $30,000 to buy a new car, paying the car loan off over seven years. An instalment loan usually comes with a fixed interest rate, but not always. Your payment is based on the length of the instalment loan and the size of the loan. The more you borrow, the higher the payment. The longer the loan, the lower the payment, although the more interest you’ll pay over the life of the loan.
In terms of debt servicing for a mortgage, the regular required payment on your credit report is used. That’s why it can be helpful to have a lower payment if you want to maximize your home purchasing power.
The most common examples of instalment loans include car and student loans.
A revolving account is borrowed money, but it works slightly differently from an instalment loan. With a revolving account, you can borrow, payback, and re-borrow the funds many times. Revolving accounts come with pre-set credit limits. You don’t want to ever go up to the limit. In fact, you want to aim to keep your balance below 50 percent of your available limit at all times; otherwise, it could negatively impact your credit score.
Three percent of the outstanding balance is generally used as the monthly payment for debt servicing. However, some lenders are more conservative and use 3 percent of the higher credit limit instead.
Credit cards and unsecured lines of credit are the most common examples of revolving accounts you’ll come across.
Although technically an installment loan, mortgages have started to be reported separately on credit reports in recent years. A mortgage that appears on a credit report is any mortgage for a property you own or are co-signing on.
Debt servicing it’s pretty easy. You use the actual mortgage payment that appears on your credit report.
Something else that might appear under the mortgage category is a HELOC. Even though HELOCs are revolving accounts, they are generally reported as mortgages.
For debt servicing, lenders usually use the outstanding balance on a HELOC and amortize it over 25 years, using the stress test rate of 5.25 percent. However, similar to unsecured lines of credit, some lenders use the credit limit rather than the balance to calculate your payment.
The last type is open accounts. An open account is most commonly an account where a service is provided to you. You’ll typically receive the service before making payment. The most common example of these is a cellphone contract. These are usually pretty insignificant, so they don’t tend to make a huge impact on debt servicing.
The Bottom Line
Confused by the different types of credit? Speak with our mortgage experts today, who can help you better understand them.