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Loans

Revolving credit vs. installment credit: What's the difference?

What's the difference between revolving credit and installment credit? While having both is important for a healthy credit score, one can be more harmful than the other.

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Having a diverse variety of credit products shows lenders how you manage different types of debts, and it can even help improve your credit score. Your mix of credit counts as 10% of your credit score calculation on the FICO scoring model, which lenders use to determine whether you are a good borrower.

The two most common types of credit accounts are installment credit and revolving credit, and credit cards are considered revolving credit. To make the most of both, you'll need to understand the terms, including what your monthly payments will be and how they both show up on your credit report.

Below, CNBC Select breaks down what you need to know about installment and revolving credit accounts, plus the impact of each on your credit score.

1. Installment credit

Installment credit is a loan that offers a borrower a fixed, or finite, amount of money over a specified period of time. This way, the borrower knows upfront the number of monthly payments, or "installments," they will need to make and how much each monthly payment will be.

"Everything is spelled out," Jim Droske, president of the credit counseling company Illinois Credit Services, tells CNBC Select. "You borrow a specific dollar amount for the loan, and the payments, interest rate and the length of the term are all spelled out."

For example, a bank may provide you a loan to purchase a new car with a 63-month term. This essentially acts as a payment schedule that means you would make the same monthly payment for a set 63 months to pay off that loan and its interest. With each payment installment that you make, your balance decreases, and at the end of the 63 months your loan is paid off.

In addition to auto loans, installment loans also include student loans and mortgages. The repayment periods for such installment loans can last months or years, depending on the terms of the loan. You can opt for smaller monthly payments by agreeing to pay for the loan over a longer time frame, or you can make larger payments over a shorter term. The ability to choose your repayment schedule is a helpful feature of an installment loan.

How it impacts your credit score: Because each loan on your credit report is included in your credit history, it helps to have an installment loan to show a variety of credit accounts and to add to the longevity of your credit history.

But it's worth noting that the actual balance of your installment loan isn't a big factor in your credit utilization rate, or the ratio of how much you owe to the amount of available credit you use. In fact, it's OK to have a large installment loan balance in the eyes of lenders as long as the monthly payment isn't too large for your income level. According to a VantageScore blog post (the other popular credit scoring model besides FICO), "you can easily have VantageScore credit scores well above 700, even with hundreds of thousands of dollars of installment debt. In fact, Prime consumers typically carry $100,000 to $105,000 in total debt."

While this is true, it is important to factor in the long-term costs of carrying large loans. The longer you are in debt, the more interest you pay over time. So while it may not damage your score very much, remember that you'll be paying for the loan until it's paid off.

That said, it can be easier to budget for installment loans since the monthly payments are predictable. As long as you make your scheduled monthly payments for an installment loan on time, your credit score will improve. Payment history makes up 35% of your FICO score calculation, so it's important you don't miss a due date.

2. Revolving credit

In contrast to installment credit, revolving credit extends borrowers a line of credit with no determined end time, and they can spend up to their assigned credit limit. 

"It's an ongoing 'open-end' credit obligation," Droske says.

The biggest example of revolving credit is a credit card; the cardholder routinely makes charges, pays them off whether in full or partially, makes more charges and so on. The amount of money the borrower uses within their credit limit is up to them and there is no set monthly payment plan. The borrower has the option to pay their balance off in full each month (which we recommend) or they can pay just the minimum and carry, or "revolve," their balance to the next month (which usually means accruing interest).

How it impacts your credit score: Likewise with installment credit, it's critical that you pay your monthly bill on time to have the best credit score. And ideally, you pay off the balance every month. Revolving credit is highly influential in calculating your credit utilization rate, which is the second biggest factor (after payment history) that makes up your credit score.

Experts generally recommend borrowing, or using, less than 30% of your credit limit. As you keep paying off your revolving balance, your credit score will go back up as you free up more of your available credit. 

Here's how to prevent having to pay off revolving debt

You should aim to never carry a balance on your credit card from month to month because you'll then accrue interest, which can get costly quickly.

If you are shopping around for a new credit card, you may want to consider one with an introductory 0% APR period. Most zero interest credit cards require having good or excellent credit to qualify, so make sure you check your credit score before applying.

For those with good credit, the Wells Fargo Platinum Visa® card offers zero interest for the first 18 months on purchases and qualifying balance transfers (after, 16.49% to 24.49% variable APR). The card also comes with no annual fee.

For those with good or excellent credit and also seeking rewards, the Chase Freedom® offers zero interest for the first 15 months on purchases (after, 14.99% to 23.74% variable APR). The card has no annual fee and new cardholders can earn $200 cash back after spending $500 on purchases in their first three months. Chase Freedom has a rotating rewards program that offers 5% cash back on up to $1,500 in combined purchases in bonus categories each quarter you activate (then 1%) and 1% cash back on all other purchases. From July through September, cash-back bonus categories include Amazon.com and Whole Foods Market.

Don't miss: Revolving credit debt drops to $996 billion—the lowest since the great recession

Information about the Wells Fargo Platinum Visa® card and Chase Freedom® has been collected independently by CNBC and has not been reviewed or provided by the issuer of the card prior to publication.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.