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Whether you’re trying to improve your credit or looking at a large purchase, chances are you’re hearing about installment loans. These types of loans are very common and can help you afford more expensive items over time and improve your credit if handled correctly.
Let’s get into what installment loans are, how they work and how they can affect your credit.
An installment loan is a loan that breaks up the payments over a specific period of time. The payments are also the same amount throughout the term of the loan. Installment loans are different from revolving debt, such as credit cards, because the loan is for one lump sum and is paid out every month over time in installments.
For example, if you get a personal loan for $10,000 for house repairs, you pay the $10,000 off in smaller payments every month until the balance is zero.
With revolving credit, you can keep accessing the same amount of credit as you pay it off. So if, for example, you have a credit card with a $10,000 limit and charge $5,000, once you pay off the $5,000, you have access to the full $10,000 again.
An installment loan is any type of loan that’s being paid off over time from a starting balance to a balance of zero. Common examples of installment loans are:
Installment loan terms differ depending on the type of loan. Term lengths can be very short, such as two or three years in the case of vehicle or personal loans, but can go all the way up to 30 years for a traditional mortgage. Interest rates also vary widely by type of loan and your personal credit history.
Another thing to be aware of is whether a loan is secured or unsecured. Secured loans have some type of collateral, such as with home and auto loans.
Student loans and personal loans are unsecured because there’s nothing the lender can take back to recoup their money if you don’t pay. This usually means unsecured loans have higher interest rates or lower borrowing limits as well.
An installment loan can help your credit in most situations. The key is that you want to be sure you make your payments on time every month and in full to help build positive credit history. However, there are some factors involved in getting an installment loan that could hurt your credit in the short term.
An installment loan increases your overall debt, which can change your credit utilization ratio. It also decreases the average age of your credit, and it will add a hard inquiry—which is what happens when a potential lender checks your credit.
In most cases, if you pay the loan as agreed, these initial hits are minimal and will be outweighed by the credit building over time, but they’re something to keep in mind if your credit is borderline and you’re only getting an installment loan to try to increase your credit score.
While it may seem like a good thing to pay off your installment loan, you might be surprised that it can have a negative impact on your credit in the short term. This is because it can decrease your credit mix if it was your only installment loan, and it counts as closing an active account.
However, it also decreases your credit utilization and overall amount of debt, which is good for your long-term credit. So you may notice a small dip in your credit when you pay off your installment loan, but it should recover over the next few months.
Some of the pros of getting an installment loan are:
While installment loans are usually fairly straightforward, there are some potential pitfalls to be aware of:
It’s possible to get an installment loan even if you have fair or poor credit, but you’re going to end up with less favorable terms. To get the best rates, check with credit unions and online lenders to see if you can prequalify so you know what your terms might be without racking up hard inquiries on your credit.
You may also want to consider getting a cosigner, which can help you get more favorable terms if the cosigner has better credit.
Whether an installment loan is the best choice for your situation depends on the particulars. If you need to finance a new purchase such as a car and can afford the payments, it can help you get what you need now and build credit over time.
However, it’s important not to overextend yourself because missed payments or a repo can bring your credit down even further.
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