How Do Installment Loans Affect Your Credit?
February 4, 2020 | By Mason Roberts
Your credit score is much like your dating profile, except you’re not looking for love, you’re looking for money—or, I suppose, you could be looking for deep pockets on your beau. I don’t judge. Regardless, 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 rap sheet. So, how does an installment loan weigh in on things? Well, let's first define what an installment loan is, and then let's dig into the nitty-gritty of what it can do to your credit score.
What Are Installment Loans?
Installment loans are the bread and butter of loans. An installment loan is a sum of money that you take out on a loan, and agree to pay back over a set time 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, which can make them useful 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:
- Personal loans
- Car loans
- Student loans
Why Do Installment Loans Affect My Credit?
Any type of lending, including through an installment loan, is reported by the lender to credit agencies. These agencies’ jobs are to keep a record of what you have borrowed, how successfully you have paid it back, and then calculate that into a score between 300 and 850, and 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 loan—if at all. Before you do any borrowing, make sure you know what your credit score is.
How Do Installment Loans Positively Affect Credit?
Credit is typically based off of these items: new account activity, payment history, length of history, amounts owed, and diversity of accounts. Just by applying 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. When you use an installment loan and pay it off on time over time, you begin to create a profile for yourself that indicates you are a responsible borrower, which builds your credit score and opens doors to other lenders and larger sums.
Installment Loans with Preexisting Debt
If you’ve already dug yourself into debt, it’s not the end for your credit score. In fact, depending on the nature of your situation, you might be able to utilize an installment loan to build your credit back up! Let’s say for example that you have quite the sum situated in a car loan, and your previous low credit score left you with a high-interest rate at the dealership. Do a little research into a credible alternate installment loan with a lower interest rate to help yourself in the long run.
If you transfer your debt into that new loan and pay off the one with the higher interest rate, then you’ll have an easier time handling the money you owe, and build your credit in the process.
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 requirement. 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. This would best be used in avoiding 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 of time when your score dips; however, if you pay off the loan within the agreed-upon time responsibly, then your credit will be far greater than prior to your consolidation. It’s vital to keep in mind that this method only works if you use the loan to retire existing debt as opposed to 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 affecter on your credit score. The calculation is current loan balances divided by original loan amounts equals installment loan utilization. The higher your utilization percent is, the higher you are as a risk, which lowers your credit score. This is because 30% of your credit score comes from amounts owed, and that is derived from your utilization’s 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 default on the loan, which really, you don’t want to do on any method of money borrowing.
A hard inquiry from applying for an installment loan will briefly lower your score until you have shown that you can responsibly make payments on the new loan. This happens with any newly opened loan, and is not necessarily unique to an installment loan; however, what is unique to an installment loan is paying off your loan early.
If you pay off your loan earlier than the supplied time, there are both positive and negative effects. Positively, you will obviate the interest you would have otherwise paid on the loan, thereby saving money. 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 actually 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 for existing debt and 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.