An installment loan is a type of loan where the principal amount is repaid over time in periodic installments. The borrower usually pays a fixed periodic payment that includes both principal and interest. Common examples of installment loans are auto loans, mortgages, and personal loans.
As the borrower makes timely payments over the loan term, it can positively impact their credit score. However, missing or late payments can negatively impact the credit score. This comprehensive guide discusses how taking an installment loan and making timely payments affects a borrower’s credit score over time.
What is a Credit Score and Why Does it Matter?
Before we dive into how installment loans impact credit scores, let’s first understand what exactly a credit score is and why it’s important.
A credit score is a three-digit number that represents a consumer’s creditworthiness. It gives lenders a quick snapshot of the probability that a borrower will repay their debts as agreed. The most widely used credit score model in the United States is the FICO score, with scores ranging from 300 to 850.
Higher credit scores signify lower credit risk to lenders. Consumers with higher credit scores generally receive better terms on loans such as lower interest rates and larger loan amounts. On the flip side, consumers with lower credit scores are seen as riskier borrowers and may face higher borrowing costs or even loan denials.
Maintaining a good credit score over time ensures continued access to credit when needed for major purchases or financial emergencies. It also results in savings on interest expenses over the lifetime of loans. That’s why monitoring and building your credit score is crucial for financial health and flexibility.
What Factors Determine a FICO Credit Score?
The FICO credit score algorithm considers five main categories of credit data to calculate a score. The relative importance of each category is:
- Payment History (35%): This includes information on how timely you have paid your credit accounts in the past. Late payments, missed payments, bankruptcies, foreclosures, judgments, and charge-offs are all considered. Timely payments significantly boost credit scores.
- Amounts Owed (30%): Also called credit utilization ratio. This is the ratio of total balances versus total credit limits across all revolving accounts like credit cards. Lower utilization ratios positively impact credit scores.
- Length of Credit History (15%): Calculates the age of your oldest credit account, newest credit account, and average age of all accounts. Longer credit histories strengthen your score.
- Credit Mix (10%): Mix of credit accounts including installment loans (mortgages, auto, student, personal loans) and revolving credit (credit cards). A healthy mix improves creditworthiness.
- New Credit (10%): Number of new credit applications and inquiries in the recent past. Too many new accounts may lower scores slightly.
As you can see, payment history carries the most weight, followed by amounts owed and length of credit history. Now let’s look at how taking an installment loan impacts the key FICO score factors over time.
How an Installment Loan Positively Affects Your Credit Score
When a consumer takes an installment loan like a mortgage, auto loan or personal loan, and makes timely monthly payments, it positively impacts their credit score in multiple ways over time:
- Builds a Strong Payment History: Making regular on-time payments every month demonstrates responsible repayment behavior. Each on-time payment is reported to the credit bureaus and counted in your payment history – the single most important factor in your score. A long track record of timely payments significantly raises credit scores.
- Increases Credit Mix: Installment loans add to the mix of credit types in your credit report. Maintaining installment loans (closed and open) along with revolving credit is ideal for credit mixing and strengthening scores.
- Lengthens Credit History: The installment loan remains on your credit report for several years, benefiting your scores in the long run. As this tradeline ages over time, it expands the length of your credit history.
- Lowers Utilization: When you take an installment loan, it usually means more credit is available to you, thereby reducing your overall credit utilization if you don’t increase balances proportionately. Lower utilization lifts scores.
- Adds New Positive Tradeline: Each on-time installment loan payment gets reported to the credit bureaus monthly. This builds a positive track record with this new tradeline on your report.
The combined effect of the above credit score factors results in a gradual improvement in scores as you continue to pay the installment loan on time over months and years. The longer you maintain the loan responsibly, the greater the long-term gain in scores.
How Missed Payments Negatively Impact Credit Scores
While timely repayment of an installment loan systematically improves credit scores, missed or late payments severely damage creditworthiness. Here are some of the key ways delinquent payments hurt credit scores:
- Damages Payment History: Every 30-, 60- or 90-day late payment is marked as a negative item on your payment history. Multiple late notations indicate higher risk of default to future lenders. This can cause a substantial drop in scores.
- Lowers Available Credit: Delinquent loans eventually get charged off or reach collections. When that happens, these accounts get closed thereby directly reducing your total available credit. This spikes credit utilization ratios and lowers scores.
- Adds Negative Tradelines: Collection accounts and charge-offs from missed installment loan payments appear as separate negative tradelines on your credit report, dragging down scores for years.
- Resets Positive Payment Record: After resolving late payments, you have to start rebuilding your payment history from scratch with new on-time payments. This delays your progress in raising scores through responsible financial behavior.
In short, missed payments undo much of the good credit reputation you built up over time. It takes diligent work to recover from the effects of delinquencies or defaults.
How Long Do Closed Installment Loans Impact Credit Score?
Closed installment loans, meaning paid-off loans that are no longer active, remain on your credit report for many years depending on the credit bureau. Here are the general rules:
- Equifax: Closed positive accounts stay for 10 years. Closed negative accounts stay for 7 years from the date of first delinquency. Bankruptcies stay for 10 years.
- Experian: Both open and closed accounts are reported for as long as they are positive or negative. There is no set limit on reporting period. Bankruptcies stay for 10 years.
- TransUnion: Closed accounts in good standing remain for 10 years. Negative items including late payments remain for 7 years from the first date of delinquency. Bankruptcies stay for 10 years.
As you can see, closed installment loans – whether paid on time or defaulted – can impact your credit score for 7 to 10 years beyond the loan term. Paying them off responsibly helps credit; defaults and delinquencies damage scores for many years.
Best Practices for Managing Installment Loans to Build Credit
If your goal is to use installment loans to build long-term good credit, follow these best practices:
- Review loan terms to ensure you can manage the monthly payment based on your budget. Don’t take a loan where the payment stretches your budget too thin.
- Sign up for automatic payments from your bank account to avoid missed due dates from forgetfulness or errors. Automated payments virtually guarantee on-time payments.
- If facing financial hardship, communicate proactively with the lender before missing payments. Discuss hardship programs or alternative repayment options. Don’t let an account become delinquent.
- After paying off a loan, keep the account open if permitted by the lender. Closed positive accounts fall off your report sooner than open accounts.
- Apply for installment loans sparingly, such as when absolutely needed. Too many new accounts and credit inquiries can lower scores temporarily.
- Maintain low utilization on revolving accounts while paying off installment loans to maximize score gains over time.
Following responsible credit practices ensures timely installment loan payments consistently strengthen your credit standing and FICO scores month after month.
- Taking an installment loan and consistently making on-time monthly payments has a positive impact on credit scores over time by demonstrating responsible repayment behavior.
- Missed, late or delinquent payments on an installment loan can severely damage credit scores and undo years of careful credit management.
- Paid-off installment loans continue influencing credit scores positively or negatively for around 7 to 10 years after closing depending on your credit bureau.
- Automating payments and maintaining contact with lenders prevents missed payments that lead to credit score damage.
- Applying conservatively for new installment loans balanced with low credit card utilization results in ideal credit profile for maximal long-term score gains.
FAQs on Installment Loans and Credit Scores
Q: Do all installment loans affect credit the same way?
Not necessarily. Mortgages and auto loans tend to have a more positive impact than personal loans or short-term payday loans. The major factors are your payment history and the loan amount versus other balances.
Q: Can getting an installment loan hurt my credit?
Simply taking an installment loan responsibly does not hurt yourcredit. However, applying for too many loans in a short period can result in multiple hard inquiries that may temporarily lower your score. Taking a loan you cannot afford the monthly payments for can also lead to missed or late payments that damage credit.
Q: How long do closed installment loans stay on your credit report?
Most installment loans remain on your credit report for 7-10 years after being closed or paid off. This includes both positive and negative payment history associated with the loan. Closed accounts in good standing continue benefitting your score the longest.
Q: Should I pay off an installment loan early to improve my credit score?
There is no universal answer. Paying off a loan faster means less interest paid, which is financially wise. However, keeping a loan open with an on-time payment history for the full term gives more long-term value for credit building. Evaluate your specific situation.
Q: Does refinancing an installment loan hurt your credit score?
A refinance alone does not hurt your score. Hard inquiries and higher balances from cash-out refinancing may have a small temporary effect. But if you continue making on-time payments, refinancing has a minimal impact long-term. Just avoid refinancing too frequently.
Q: If I default on an installment loan, how long before it stops hurting my credit?
The negative impact of defaulting on an installment loan can last 7-10 years. A default causes severe damage to your credit scores. Even after resolving a default, it takes years of rebuilding credit with new positive accounts and on-time payments to fully recover.
Responsibly managing installment loans over their entire loan term enables borrowers to systematically build good credit and higher FICO scores. Each on-time monthly payment contributes positively to your payment history – the most important factor in your score. At the same time, missed payments can rapidly undo years of careful credit management and lower scores substantially.
By understanding how different credit behaviors influence your credit score factors, you can strategically use installment loans to establish long-term good credit. Automate payments, maintain contact with lenders, and only take loans you know you can repay on time. With this approach, installment loans provide an accessible path to strengthen credit profiles.