Many people think that all kinds of debts are created equal and as a result, they have equal weight on your credit score, but this is not true.
There are many factors that play a role when it comes to credit scores and how they are calculated. Credit scoring models take into consideration what debt you have and how much of it. Also, they consider how your installment debt.
When you understand which metrics matter most pertaining to your credit scores, you’ll be able to improve and maintain them. In this article, you’ll find the answers to your questions.
What is an Installment Loan?
“An installment loan is a broad, general term that refers to the overwhelming majority of both personal and commercial loans extended to borrowers.” — Investopedia
Installment loans are how people borrow money, which they usually need to purchase a house, car, or use it for a college education.
After the loan gets approved by a creditor, the borrower receives their sum of money, which they then repay by paying monthly payments — known as installments — over a period of time.
As with any type of borrowing, making an installment loan can affect your credit score, may that be by improving your credit history and enhancing your credit scores, or by having a negative impact.
Here’s how it works:
How Installment Loans Promote Credit Score Improvements
Your credit reports are gathered at national credit bureaus such as Equifax and TransUnion. These agencies document your lending history and how you repay your debts.
Every loan you make is reflected on your credit report and expands your credit history.
Installment loans can improve your credit score for the following reasons, in order of importance:
- Optimize your payment history. How you pay your installments is the biggest factor contributing to your credit score. It makes up 35% in the FICO credit score model.So, understanding the huge influence this has, you can strengthen your credit by consistently paying all your installments in time. Your lender then reports your activity to the credit bureaus.
- Another factor that plays a slightly lesser role but still important is your credit mix. That means having various forms of credit could benefit your credit score as well.If currently, you don’t have an installment loan, you can get a modest boost to your score by adding one to your account mix, once it’s approved.But if your budget can’t afford the monthly payments, it wouldn’t be wise to do this, just to enhance your credit score.Keep in mind that when you make an application for a loan, will lead to a credit check, which will in turn cause a temporary plunge to your score.
- Finally, installment loans can improve your credit score by using that loan to pay off your credit cards.When you move your credit card debt on an installment loan, you reduce your credit utilization ratio. This ratio is also an important factor to your credit score, granting up to 30% to it according to FICO.
The Short-Term Negative Effects Installment Loans Have on Your Credit Score
Whenever you make an inquiry for a loan, whether it’s a revolving or an installment loan, your creditor makes a credit inquiry against your report. That can cause a temporary small drop in your credit score.
A credit inquiry describes what happens when someone asks for your credit information. It’s when a party sends an ‘inquiry’ for your credit report from the credit bureaus. Then those bureaus can share your information with the party who asked for it and has a legal right to it. You have always the right to ask and find out who accessed your credit report.
This reduction of your credit score is completely normal, as it reflects the statistical probability that lenders who seek to make a new loan are seen as more prone to defaulting on their other loans.
As long as you keep paying your bills on time consistently, those short-term impacts on your score will recover in a few months.
How Different Credit Scoring Models View Your Installment Loan Debt and Why?
FICO and VantageScore are the two most popular credit-scoring models.
They focus on the different types of accounts you hold, rather than how you repay your debt.
For example, one type of debt might have a low influence on your credit score, where others can really make your score plunge, even if you pay your installments on time.
Both credit-scoring models treat your installment and revolving debt very differently. Of course, they take into consideration your payment history and the amount of debt you owe on your accounts, but the weight of each type of loan has on your credit score is vastly different.
For example, you may have a small $3000 low-limit credit card balance, and a $450,000 mortgage balance, and the credit card debt will have a more negative impact on your credit score than the mortgage loan.
The reason why these types of loans are treated unequally is that installment debt is typically secured and less risky, whereas revolving debt is more indicative of high credit risk and hence will have a more damaging impact on your credit score.