What Is an Installment Loan, and Will Having One Improve Your Credit?

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As you educate yourself about how to improve your credit score, you may have come across the advice that you need to have some type of installment loan on your credit report. What exactly is an installment loan, and is it true that having one can improve your credit? Whether or not an installment loan will help you depends on your individual financial situation and credit report. It could help your credit, but it could also harm it, or it might even do very little at all.

Installment Loans Explained

There are two main types of debt: revolving accounts and installment loans. When you open a revolving account, you are usually issued a line of credit, and you are able to use that credit whenever you choose. In addition to deciding how much of your available credit to use, when you have a revolving account, you can choose to either pay the balance in full at the end of the month, or “revolve” some of it to the following month. Anything you don’t pay off accrues interest. In addition, payments on a revolving account usually fluctuate monthly depending on the balance of the account. Credit cards and home equity lines of credit are the most common types of revolving credit.

Installment accounts are different. With an installment account, you borrow a certain amount of money from a lender, and agree to pay it back—plus interest—by making regular payments for a fixed amount of time. Payments are usually monthly, and the total repayment period for an installment loan can range from months to years. A mortgage or a car loan are common types of installment loans.

Potential Benefits

In many cases, having an installment loan can improve your credit score. One way that it can do so is by diversifying your credit mix. Most lenders like to see that you are able to handle a variety of different types of debt, so having an installment loan in addition to a revolving account might raise your credit score. According to FICO, 10 percent of your FICO score is determined by your credit mix.

Another way that an installment loan could be beneficial is if you use it to pay down high balances on credit cards or other types of revolving credit. If you have high credit card balances, you may have a high credit utilization ratio. This means having a large amount of debt compared to the amount of credit you have been given. Your credit utilization ratio is a major component of your score for both FICO and VantageScore, with a higher ratio causing a lower score. This ratio is based mainly on revolving credit card debt, not installment debt, so by transferring your credit card debt to an installment loan might be able to lower your credit card utilization ratio, and improve your credit score.

Transferring a revolving debt to an installment loan might also help you manage your debt better because you will have a set payment schedule, and with an installment loan—unlike a revolving account—you can’t continue to keep adding to that debt. However, this only works if you do not continue to make new charges on the revolving account.

Credit Improvements May Be Small

If you are thinking about applying for an installment loan in order to improve your credit, you need to be aware that while this type of loan could improve your credit, there is also a chance that any improvements will be relatively small. One reason that installment loans may only have a small effect on your credit is that they don’t involve as much risk as revolving accounts. Installment loans have a set payment schedule, and they are usually secured by an asset like a house or a car. In contrast, as Experian explains, credit cards can show more about how well an individual can handle credit because they allow more control over how that credit is used. For this reason, Experian advises that a credit card might help you build your score more quickly than an installment loan.

In fact, an installment loan could initially cause a small decrease in your credit score. Applying for any type of new credit involves a credit check, and that can reduce your score by a few points. In addition, as Experian explains, like any new type of debt an installment loan can cause a temporary drop in your credit scores because the new loan has no payment history associated with it, and there is uncertainty over whether or not you will be able to handle this new debt. Finally, if you open too many new accounts of any type in a short period of time, your score can be lowered.

Paying Off an Installment Loan

Paying off an installment loan also affects your credit. Some people are surprised to find that when they pay off their loan, they see very little improvement in their credit score. VantageScore explains that this is because an installment loan often has only a minor impact on your credit score to begin with. In some cases, borrowers even try to pay off an installment loans early in order to avoid interest or just to reduce overall debt, but there may be very little benefit in doing that. According to Experian, paying the loan off on time may actually have about the same effect on your credit.

Some people find that it is actually beneficial to keep the account open rather than paying it off early, because of the fact that payment history does have a significant impact on your credit score. Equifax explains your payment history constitutes about 35 percent of your credit score, so it can be much more beneficial to your credit to keep making regular, on-time payments rather than closing an installment account.

Overall, an installment loan might help improve your credit, however most experts advise caution when thinking about taking on a new loan, and recommend not taking out a loan unless you actually need it. If you are planning to apply for any type of installment loan, you should try to have your credit in the best shape possible before you do so, which means you should review it, and correct any errors.

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