It is undeniable that your credit score is a major aspect of your financial health. Understanding how things affect your credit score is the first step to taking control over your financial health and making sure you don’t put yourself in a bad position when you take out a loan. Read on to understand how an installment loan will affect your credit score.
What is an Installment Loan?
An installment loan is not a tough concept to wrap your head around. It is simply a loan where you pay the lender part of the debt in regular intervals (installments), such as monthly or bi-monthly payments. Some examples of installment loans you might see in your daily life include auto loans (often requiring 48 evenly spaced monthly payments), mortgages, student loans, home equity loans, and others.
Why would an installment loan affect my credit score?
Installment loans are reported by the lender to credit agencies, such as Experian or Transunion. These companies gather consumer credit information and compile it into a credit report, which helps potential lenders quickly understand your past credit history.
Why do installment loans affect my credit score similarly to credit card debt?
When you pay off the balance of a major installment loan, your credit score might not go up very much, compared to if you paid off a credit card. There are a few reasons why they are treated differently:
- A lot of what goes into your credit score is risk prediction. Lenders want to know if you are probably going to pay off your debt, or if you are in danger of falling behind.
- Installment loans have different risk prediction abilities than credit cards.
- They are more regular, and you are more likely to pay them because they are backed by some collateral or equity on behalf of the borrower.
- Credit cards are much less stable. Borrowers make different types of purchases on credit cards and also don’t have the added incentive of wanting to keep their collateral.
The effect of installment loans on your credit score is not great to begin with since there is usually not much of a chance that the loan will not be paid back as agreed. So it makes sense that when you pay the loan off, your credit score is not going to skyrocket. However, there are a few ways in which it does affect your score.
Timing and Late Payments
When paying off an installment loan, you should focus on making regular payments on time rather than the overall loan balance. That’s because the most major way your installment loan could ding your credit score is if you are messing up on making regular payments.
Installment loans will not negatively affect your score as long as you are paying on time. That’s because when you first get a loan, credit agencies understand that the loan balance will be relatively high during the beginning of its lifetime. Because of this, they forgive of large loan balances.
How can an installment loan actually help my credit score?
One of the major benefits of taking out an installment loan is that you will diversify your portfolio of loans. Having different types of loans open and proving you can pay them off is a major asset for your credit history. Lenders are more comfortable giving you a loan if they can see your borrowing behavior in a variety of different contexts.
Some potential negative impacts?
Unfortunately, you might have slight negative impacts from the loan as well. Regardless of what loan you get, it will impact your debt-to-credit ratio. If you are using more of your allotted credit, then your credit score will be slightly lower over time. The higher your loan balance, the more effect this will have. So as you pay your loan off over time, this will be less important.
When you apply for a loan, the lender has to perform a hard credit check. This reduces your credit score slightly for a short time, but not by much.
Payment history makes up a full 35% of your credit score. Making repeated late payments is one of the worst things you could do for your credit.