How Installment Loans Affect Your Credit Score
Written by: Dwayne D.
Published on:
Your credit score affects many of your financial decisions. You must have good credit standing when you are applying for an apartment or getting a new credit card. Your credit score will affect how attractive you look in the eyes of banks and lenders, and if you ever want to borrow money, you will need to make sure you have a decent credit history. So, how does an installment loan weigh in on things?
How Installment Loans Affect Your Credit Score
Installment loans involve borrowing a fixed amount of money and repaying it over time in set installments. They can influence your credit score positively or negatively, based on how well you manage them.
Positive Effects on Your Credit Score
- Builds payment history. Timely payments help establish a strong payment record, which is crucial to your credit score.
- Improves credit mix. Having both installment and revolving credit shows lenders you can handle various types of debt.
- May reduce credit utilization. Using an installment loan to pay off credit card debt can lower your credit utilization ratio, boosting your score.
Negative Effects on Your Credit Score
- Hard inquiries. Applying for a loan can slightly and temporarily reduce your score due to a hard credit check.
- Increased debt load. Adding a new loan raises your total debt, which may negatively impact your score.
- Late or missed payments. These can severely harm your credit, as payment history is a major scoring factor.
- New account impact. Opening a loan may lower the average age of your credit accounts, slightly affecting your score short-term.
How Do Installment Loans Appear On My Credit Report?
Installment loans show up on your credit report as a specific account. The report includes details like the loan amount, current balance, payment history, and terms.
How well you manage the loan has an impact on your credit score, with timely payments raising your score and late payments lowering it.
Do Installment Loans Build Credit?
Do installment loans help your credit score? The answer is that it depends. Credit is typically based on these items: new account activity, payment history, length of history, amounts owed, and diversity of accounts.
By applying for and taking out a loan, you begin your credit journey and tick off boxes in the new account activity, diversity of accounts, and length of history categories. Then, when you take out an installment loan and pay it back over time, you show that you are a responsible borrower. This raises your credit score and lets you borrow more money from other lenders.
So, what can we conclude, are installment loans good for your credit? The answer is that it all depends on you.
Installment Loans with Preexisting Debt
If you've already got yourself into debt, it's not the end for your credit score. Depending on your situation, you might even be able to use an installment loan to get your credit back on track! Let's say, for example, that you owe a lot on a car loan, and because you had a low credit score before, the dealership charged you a high-interest rate. Find a trustworthy alternative to an installment loan with a lower interest rate by doing some research. This will help you in the long run.
If you transfer your debt into that new loan and pay off the one with the higher interest rate, you'll have an easier time handling the money you owe and building your credit.
Debt Consolidation for Credit Cards
The same can be said with credit card debt. Credit cards work on a system of revolving debt, meaning that they have a range of credit to be used and must be paid on a flexible monthly basis. If your credit score has taken a hit from outstanding debt on your credit card, then an installment loan can take some of that weight off and assist you in paying it off with smaller interest rates. But, again, this would best be used to avoid maxing out your credit card, which you'd want to avoid because it increases your credit utilization rate and significantly lowers your credit score.
Debt consolidation does hurt your credit score, albeit temporarily. Since you are taking on more debt, you will go through a period when your score dips; however, if you pay off the loan within the agreed-upon timeframe, your credit will be far greater than before your consolidation. It's vital to remember that this method only works if you use the loan to retire existing debt instead of taking on more.
Installment Loan Utilization
Installment loan utilization is a calculation that evaluates how much you owe on your loans and is the primary factor in determining your credit score. The calculation is current loan balances divided by original loan amounts equals installment loan utilization. The higher your utilization percentage, the higher your risk, which lowers your credit score.
This is because 30% of your credit score comes from amounts owed, which are derived from your utilization scores; however, there is a plus side to this. A high installment loan utilization percentage does not harm your score nearly as much as a high credit card utilization percentage, so even though you may owe quite the sum, it is much better to do so through an installment loan than through revolving credit.
How Installment Loans Negatively Impact Credit Scores
Most of the ways that an installment loan can negatively affect your credit score are minor and temporary—the only way it would greatly affect your score is if you failed to make your payments on time or if you defaulted on the loan, which really, you don't want to do on any method of borrowing money.
When you apply for an installment loan, a hard inquiry will temporarily lower your credit score until you show you can repay the new loan responsibly. This happens with any newly opened loan, which is not necessarily unique to an installment loan. However, paying off your loan early is unique to an installment loan.
If you pay off your loan earlier than the specified time, there are positive and negative effects. Positively, you will obviate the interest you would have otherwise paid on the loan, thereby saving money. However, negatively, your account diversity and length of history will take a hit once you have closed the loan, which collectively impacts 25% of your score.
Installment Loans and You
Installment loans are not inherently good or bad. It all depends on your ability to handle debt and whether or not you understand the terms of your loan. You can use an online installment loan to consolidate debt and build credit simultaneously, so long as you do so to pay off existing debt, not to create more, and so long as you have found a loan that provides a better interest rate and timeline. The perks of this process, and of taking out a loan in general to build your credit profile, will outweigh most cons so long as you borrow responsibly.
