How installment loans influence your credit score

How installment loans influence your credit score

Have you thought about the influence of installment debt to your credit score? It seems like many people are wondering what that is. Like in many things in life, especially with financial matters, the answer to that question depends on many different things as there are many factors to consider and each situation is unique.

Taking out an installment loan may really hurt or help your credit score. That depends on things like how you are utilizing the loan. Installment loans, like most forms of borrowing, can be quite beneficial to your overall financial stability, if managed right. They can improve your rating, put you in a better position when qualifying for other loans, make it easier to get better loan terms and rates and stabilize your finances.

What is an installment loan

Installment loans are loans in which the borrower has to repay in scheduled amounts (installments) over a fixed period of time. It can be five months, five years or longer. Installment loans include mortgage loans, car title loans, personal loans, student loans and many others.

How installment loans can help your credit score

How installment loans can help your credit score
How installment loans can help your credit score

Installment loans can help your credit score when, for example, you use the money to pay off more costly revolving debt or expand the diversity of your consumer report.

  • Account types diversity

By adding diversity to your borrowing history, taking out an installment loan can really improve your credit score. When a lending company is considering whether or not it should lend you the amount of money you desire, they look at your borrowing experience diversity much like you’d observe someone’s behavior at work or with his friends if he wants you to lend him a certain amount of money. The algorithms that lending company use operate in a very similar way. Taking out different types of installment loans could really expand your diversity.

  • Utilization Ratios

Taking out a new installment loan in order to consolidate an existing one can decrease the utilization ratio which may then temporarily help with your credit score. 30% of your rating is made up of your revolving credit ratio.

Installment loan borrowers are able to consolidate their installment debt into just one account and by doing so, they get a few benefits. That way the borrower has less accounts to manage every month, the interest rate of the loan lowers, and the utilization ratio on revolving debt improves which temporarily helps the borrower’s credit score.

As long the borrower doesn’t run up new balances on his existing revolving accounts, consolidating debts into one loan helps with the credit score. The utilization ratio of the installment loan is not really considered by credit scores. This variable does not predict future delinquencies but correlates with the age of the account.

How installment debt can hurt your credit score

installment debt can hurt your credit score
installment debt can hurt your credit score

Installment loans can often be swords with two edges. Borrowers realize that installment debt can actually lower their credit scores when, for instance, they open too many accounts too fast. In most cases, paying off a loan early is considered good. However, many borrowers don’t financially buffer themselves when they do that which often leads to other problems.

  • Too many loans

If you take out  many installment loans within a short period of time, it can really hurt your credit score, as well as your ability to qualify for a mortgage. As we all know, too many in any endeavor does not lead to anything good and the example here makes no exception.

The amount of new installment loans makes up another 10% of your rating.

When the algorithms see too much new loan activity, they usually tend to subtract points as that is a warning sign that a borrower may get into trouble.

The odds of delinquency also increase when you’ve taken out too many installment loans. Doing so also spikes your debt-to-income ratio and increases the total amount of debt. Your chances of falling behind on your loan account increase with every installment loan you take out.

  • Paying Off loans Early

Paying Off loans Early
Paying Off loans Early

When you pay off your installment loan earlier than scheduled, it does boost your credit score a little. But in case you haven’t calculated your budget right, it can cause you real problems. Paying off early doesn’t really get you any bonus points. The consumer report will simply say that the loan amount is repaid according to terms and that’s all.

Let’s say you decide to pay the loan in full which leaves you with little cash or none at all. You think is all fine since you’ve calculated your budget. But what if the month after that, an emergency bill comes up, someone gets sick or your car breaks down and you don’t have any money to take care of the situation? You’re going to have to take out a new loan when you could have just stick to your previous when making your fixed monthly payments.

There is probably a solution for this problem and that is building an emergency fund that can cover emergency costs. Once you have your emergency fund, you can start to think how to pay off your installment loan earlier. That way, paying off the loan earlier will not hurt you. It will help you with your credit score instead.