Have you ever wondered how installment loans affect your credit scores? It appears you may have plenty of company.
Like many financial topics, the best answer is “it depends on a number of different factors.” Each situation is unique.
Taking out a small starter installment loan can help you build a positive on-time payment history. Using the money to retire credit card debt can also improve your revolving utilization ratio.
Applying for installment loans may hurt your credit score a tiny bit for a short period. The uses for the money and your repayment behavior have a greater impact that is more long-lasting.
- How taking out small starter amounts increases ratings and helps utilization ratios
- How to avoid lowering ratings during application, consolidation, and repayment
Installment Loans to Build Credit Scores
Taking out an installment loan can help consumer build their credit scores in multiple ways – provided they borrow a small amount and repay the lender on time. You can see this across the five important factors most equations use.
- Payment history: 35%
- Amounts owed: 30%
- Length of history: 15%
- Diversity of accounts: 15%
- New account activity: 10%
Small Installment Loans
It’s easy to get a small installment loan to build your credit score. Presenting your qualifications to a large network of specialty online lenders is often the best approach. These web-based companies focus on working with consumers with limited history or a poor repayment record.
Beginning with a small starter amount makes it much easier for the lender to approve the request. The minimum credit score needed to qualify is much lower when the projected debt-to-income ratio is more affordable.
Taking out a small installment loan can raise your credit rating in three important areas.
- Length of history: start building a history of borrowing money from lenders who share your behavior to the big three consumer reporting agencies
- Payment history: Borrow a small amount so that you can easily establish a strong record of on-time payment with no glitches
- Diversity of accounts: Round out your borrowing resume by adding secured and unsecured contracts into the mix
The installment loan utilization ratio has minimal effect on your credit score. The ratio acts as a proxy for the length of time the account has been open. New account activity makes up only 10% of your rating. Lenders view new accounts with skepticism because the borrower has yet to establish that he or she can afford the payments.
Here is the simple calculation.
Outstanding balance/Original principal
Follow this simple example to see how the percentage correlates with the account age. This chart illustrates the amortization schedule for a 5-year term at a 10% annual interest rate.
|Utilization Ratio||Number of Years|
As you see from the example above, the utilization ratio for installment loans naturally improves over time. Do not confuse this percentage with the far more important revolving debt equation.
Versus Revolving Debt
A comparison of installment loans versus revolving debt can clear up the confusion about the utilization ratio and the way it affects credit scores. We should begin with two definitions.
- Consumers repay installment loans over time with a fixed number of scheduled (monthly) payments. The term can last a few months to years depending on the type of contract. These are the four most common examples.
- Cardmembers repay revolving debt over time using a flexible monthly payment requirement. The person can borrow against a predetermined limit on the account. These are the two most common examples.
- Credit cards
- Home equity line of credit
The revolving debt utilization ratio has a far greater impact on credit scores. This percentage tracks closely with the amounts owed factor (30%). Consumers carrying a large balance relative to the limit are riskier borrowers. The calculation is simple and can rise or fall every month.
Revolving balance/Credit limit
People taking out installment loans can quickly improve the revolving debt utilization ratio by using the funds to pay down their credit card debt. However, you still owe the same amount of money. It is not a get-out-of-jail-free card.
When Installment Loans May Hurt Credit
There are times and place when installment loans can hurt your credit score. Most of the factors determined by lenders are temporary and minor in their effect on your qualifications.
On the other hand, the behavior of person borrowing the money is far more impactful to qualifications and last much longer.
Applying for installment loans may hurt your credit score a tiny bit temporarily. The application and provision portion of the process is a minor issue and the effects are fleeting. What the person does afterward is far more important and long-lasting.
Three minor things happen during the application process. They have a nominal impact on credit scores for a short period.
- No credit check lenders evaluate alternative reports or based their decision on income only. The process does not log a hard inquiry on your consumer report.
- Traditional lenders pull of copy of your consumer report to evaluate your application. The hard inquiry will appear on one bureau file and drops your rating by about 5 points on average for a short period with this agency only.
- Most companies share newly opened installment loans with all three major consumer-reporting agencies. The new account will also suppress your rating until you establish that you can afford the payments (as above).
Two major things often happen after the application process. They can have a huge impact on credit scores for a long time (seven years or more).
- Consumers who use the money to finance further spending boost their debt levels. The amount owed makes up 30% of the equation. This extra debt lowers ratings. Fortunately, the amount owed changes every month.
- Borrowers began making payments six to eight weeks after the installment loan funds. Payment history accounts for 35% of the equation result.
- Positive payment history raises ratings and can remain on file indefinitely
- Negative payment history hurts ratings and disappears after seven years
Taking out an installment loan for debt consolidation hurts credit scores a tiny bit temporarily also. In fact, all of the topics addressed above in the application section hold true – expect one. The way that a consumer uses the funding often results in two opposite outcomes.
Hopefully, you fall into the first category and increase your ratings!
- People who take the debt consolidation money to retire existing obligations can lower their monthly payments, reduce interest rates, and restructure their finances.
- Longer repayment terms can lower the monthly payments
- Lower interest rates (when possible) reduce the cost of borrowing
- Transferring revolving balances helps the meaningful utilization ratio
- Consumers who use the debt consolidation money to widen the open to buy on credit cards wind up more trouble. The temptation to charge purchases leads to ballooning debt levels and an impossible situation.
Paying Off Early
Paying off an installment loan early may hurt your credit score a tiny bit. However, it is far better than the opposite – paying late! The benefits usually outweigh the drawbacks
Paying off any loan early is generally a good thing. You save money on interest charges and retire an obligation. The positive record of the account remains on your consumer file for lenders to see. It does not disappear just because you no longer owe the money.
However, prepayment of an installment loan can lower your ratings in three possible ways.
- A drained emergency fund can lead to late payments on other obligations. People lose jobs, become disabled, and surprise expenses crop up.
- The length of history (15%) may take a delayed minor hit. The account could age from your file sooner after a period of inactivity.
- Your account diversity (10%) may take a ding that appears sooner. Some people can trigger a reason code reading “lack of recent installment loan information.”