Do Installment Loans Hurt Your Credit?

Individuals often consider taking out a loan to finance significant purchases or manage their finances. A common question that arises is how these loans might affect one’s credit score. This article will explore the nature of installment loans and their interaction with credit reporting and scoring.

Defining Installment Loans

An installment loan provides a borrower with a fixed sum of money upfront. This amount is then repaid over a predetermined period through regular, fixed payments, often monthly. Each payment typically includes a portion of the principal amount borrowed and the interest charged on the debt.

Common examples of installment loans include mortgages, auto loans, student loans, and personal loans for various purposes. These are “closed-end” loans, meaning the account closes once fully repaid.

Installment loans differ from revolving credit, such as credit cards or lines of credit. Revolving credit allows repeated borrowing up to a limit with no fixed end date for repayment. In contrast, an installment loan provides a single lump sum that is paid back over a set term, and additional funds require a new loan application.

Credit Scoring Fundamentals

Credit scores, like those from FICO and VantageScore, are numerical representations of an individual’s creditworthiness. These scores are calculated based on information in credit reports and help lenders assess the risk of lending money. While specific weighting can vary between scoring models, five primary factors commonly influence a credit score.

Payment history is the most significant factor, accounting for approximately 35% to 40% of a score. This category reflects whether an individual has made payments on time across all credit accounts. The amounts owed, also known as credit utilization for revolving accounts, makes up about 30% of a score.

The length of credit history contributes to 15% of a FICO score and considers the age of the oldest account, the newest account, and the average age of all accounts. New credit, reflecting recent applications and newly opened accounts, accounts for 10% of the score. Credit mix, which considers the diversity of an individual’s credit accounts (e.g., a combination of installment loans and revolving credit), makes up 10% of a score.

How Installment Loans Influence Credit Scores

Installment loans can influence credit scores through each of the five main credit scoring factors, with the overall impact depending heavily on responsible management. For payment history, making timely payments on an installment loan demonstrates financial responsibility and builds a positive credit history. Conversely, missed or late payments can significantly damage a credit score and remain on a credit report for several years.

Regarding amounts owed, taking on an installment loan increases an individual’s total debt. However, unlike revolving credit, installment loans do not have a utilization rate; instead, scoring models consider the proportion of the original loan amount that is still owed. As the principal balance of an installment loan is paid down, it can positively affect this category.

The length of credit history can see a temporary reduction in the average age of accounts when a new installment loan is opened. However, over time, a well-managed installment loan that remains open for many years contributes positively to the overall length of credit history.

Applying for an installment loan results in a hard inquiry on a credit report, which can cause a small, temporary dip in a credit score. This inquiry remains on the credit report for up to two years, though its impact on the score diminishes after 12 months. However, credit scoring models treat multiple inquiries for the same type of loan (like auto or mortgage loans) within a short period as a single inquiry, to allow for rate shopping.

Adding an installment loan to a credit profile can positively impact the credit mix, especially if an individual primarily has revolving credit accounts. A diverse credit portfolio is viewed favorably by credit scoring models, though it is a less influential factor than payment history or amounts owed.

Information for Installment Loan Applications

Before applying for an installment loan, gathering specific information and documentation is necessary. Lenders require this information to verify identity, assess financial stability, and determine repayment ability.

Applicants need to provide personal identification, such as a government-issued driver’s license or passport, along with their Social Security Number. Proof of income is a requirement, which can include recent pay stubs, W-2 forms, or tax returns to demonstrate a steady source of recurring income. For self-employed individuals, profit and loss statements or bank statements may be required.

Lenders ask for employment history, including employer names, addresses, and dates of employment. Information about existing debt obligations, such as current mortgages, other loans, and credit card balances, is important for lenders to understand an applicant’s overall financial picture. Bank account information, including routing and account numbers, is needed for potential fund disbursement and setting up automatic payments.

The Installment Loan Application Process

The process of applying for an installment loan involves several steps. An applicant begins by submitting a loan application to their chosen lender, which can be done through an online portal, a physical branch, or with assistance from a dealership for specific loans like auto loans.

Upon submission, the lender performs a hard credit inquiry to access the applicant’s credit history and score. This inquiry becomes part of the applicant’s credit report. The lender then enters a review process, often referred to as underwriting, where they evaluate the provided information and assess the applicant’s creditworthiness.

During this review, the lender may request additional information or clarification. After the evaluation, the applicant receives notification of approval or denial. If approved, the next steps involve reviewing the loan terms and conditions, which detail the interest rate, repayment schedule, and any associated fees.

The applicant then signs the loan agreement. Loan funds are disbursed. Depending on the loan type, the money may be provided directly to the borrower as a lump sum or paid directly to a third party, such as a car dealership or a home seller.