A question that financial advisors receive quite often is: “Can Installment loans improve my credit?” This is an important question for anyone seeking financial know how to ask because it reveals a lot about how not all debts are created equal, a common misconception.
What is an installment loan?
The first step in answering this question is to understand what an installment loan is. Installment loans are when someone is lent money and the debtor must pay the creditor a fixed sum of cash for a fixed number of months. One example that most people will be familiar with is an auto loan. Specifically, the lender may require you to pay for 400$ a month for 12 months to pay off the initial sum necessary to purchase the car. Other common examples include mortgage loans, personal loans, student loans and other niche loans.
Like any loan, an installment loan will be reported to a credit agency and so one way or another will influence your credit reports. Most models used to score credit do consider them specifically when calculating credit scores. However, many curiously find that after paying of their installment debt, that there credit score never improved much at all.
Do you have bad credit?
People with less than perfect credit often look for installment loans to help rebuild their credit. There are specific lenders that can work with less than perfect credit. Installment loans are normally used for car, motorcycles, boats, and other larger purchases. You can even get installment loans for people with bad credit for smaller amounts less than $5,000.
This is because Installment loans differ from other loans in their capacity to help agencies predict risk. Take for example, a credit card debt. When credit card debt is paid off it provides the creditor with a different level of understanding because the payback time is often left up to choice in terms of time frame and amount. In contrast, installment loans are more stable and are even secured by assets that reduce risk for the creditor anyways (this is called a collateralized loan).
The collateralization tends to speak louder than a person’s tendency to miss payments because people do not want their car or home repossessed. This stability explains why installment debt has only a modest influence on your debt initially. It’s really as simple as this: the reason why paying of the installment debt doesn’t raise your credit score is because it actually never lowered it to begin with. This is why many people maintain a credit score of 700 plus despite holding over 100,000$ in installment debt.
Anyone thinking of taking out an installment loan should instead focus their attention on how well they manage the payments, rather than the lowering of a nominal balance of debt.
What about your credit score?
What will matter when it comes to an installment loan and it’s impact on your score is that you make each payment on time. The timeliness of your payments is known as your payback history.
In the end, as your balance does decline your credit score will indeed improve. However, this improvement will be subtle and won’t happen quickly. There is simply no disputing that a lower installment loan balance is better than a high one when it comes to your score. Just remember, this process can take many years depending on the size of the loan. By simply making those payments on time you will at least ensure that your scores remain as high as they can possibly be.