Installment Loans and Credit Scores

There have been a lot of questions lately about installment loans and their importance to a credit profile. Such as: Does an installment loan help or hurt? How much do the balances on installment loans affect a score?  What about the payment amount?  Is that a factor that is considered? What happens when its paid off?  Installment loans seem to be something of a mystery to a lot of consumers as far as how they do or do not affect credit scores.

First, it is important to understand what an installment loan is, so…what is considered an installment loan? This is a loan were a set dollar amount is repaid every month for a specific period of time.  Examples would be auto loans, mortgages and even student loans. These are different than revolving accounts in that revolving accounts (credit cards) are not dictated by a time limit and payment amounts change depending on the balances.

Is having an installment loan beneficial? Yes it is!  The bureau’s models like to see optimally two installment loans, for example, one auto and one mortgage is the perfect mix. And the longer you have them the better because several years of good history on an installment loan can certainly help a credit score. Plus, an installment loan and credit cards together provide diversity in your credit utilization.

Balances on installment loans are not really an issue, unlike revolving accounts where it is important to keep balances low. Balances on installment loans are not factored into credit scores in the same manner as revolving balances. There are many examples of credit reports where million plus dollar loans are paid off and it does not move the score even one point. In fact, if you have only one installment loan and pay it off, that can actually have a negative effect on the scores as the scoring models want to see at least one. The most important aspect of installment loans is to have a long history and no late payments.  Once you close an installment loan the history is gone, so it is important to have at least one installment loan at all times.

Payment amounts for any debt, whether revolving or installment, are also not factored into the scores. Payment amounts are factored into a borrower’s Debt-to-Income ratio (DTI) but they are not factored into the scores.

Another advantage to having an installment loan would be to pay off credit card balances. For example, if you took out a closed end second mortgage as opposed to a HELOC (which is revolving) or a consolidation loan you could use that to pay off credit card balances. The interest rate on these would probably be better than the rates on the credit cards, so in the long run would save money.

As with any new account, when an installment loan is first opened it will have a negative effect on the scores because it is new with no history. However, once payments are made and the history lengthens the more positive the effect will be.

Installment loans do play an important role in the calculation of credit scores. The important thing to remember is that the balances on installments loans aren’t what is important like it is with credit cards.  The important thing is the length of the history and that the payments are always made on time.