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?
Installment loans are the bread and butter of loans. An installment loan is a sum of money you borrow and agree to pay back over a set period with an agreed-upon interest rate. Typically, an installment loan's interest rate will be lower than that of debts collected on credit cards, making them helpful in transferring debt or managing a sum too large to pay off in only a few months. Some of the most recognizable types of installment loans include:
The lender reports any type of lending, including an installment loan, to credit agencies. These agencies' jobs are to record what you have borrowed and how successfully you have paid it back and then calculate that into a score between 300 and 850. The higher your score is, the better. This score helps future lenders know if you are a responsible borrower and how much they might be willing to give out on a loan. So before you do any borrowing, make sure you know what your credit score is.
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.
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.
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 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.
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 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 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.