Installment credit generally involves a loan of a specific amount and a fixed repayment schedule. Here’s how it differs from revolving credit, and how it affects your credit score.
Before there were credit cards, if you wanted to buy something but lacked the cash, you could buy it “on time.”
For just X dollars down and X dollars a month, that most precious of objects could be yours! Today, buying it on time has been replaced with installment credit. Same thing, different name. What is different, however, is that we all live in the shadow of the credit score, and installment debt may score differently from how you think.
But, as you also know, there are other factors that go into your score. One of those factors is credit mix. While it only accounts for about 10% of your total FICO score, it can be a game-changer for those looking to improve their score. All three of these factors are affected by installment credit.
Credit mix refers to the type of accounts you have. Credit cards, car loans, mortgages, student loans and just plain personal loans are all different types of accounts.
How does installment credit differ from revolving credit?
However, while there are many types of accounts, there are two major subdivisions of credit; these are revolving credit and installment credit.
Revolving credit is characterized by choice. You have the choice of how much credit you use, how much you repay and how long you can take to pay it back – all within the bounds of your agreement with your creditor, of course.
All of this choice disappears with an installment loan. The terms are generally fixed. You borrow a fixed amount for a set time and you have a fixed payment. So, you can see why mastering both types of debts would enhance attractiveness as a borrower and your credit score.
Revolving credit can be personal lines of credit, home equity lines of credit and, of course, credit cards. Falling under the installment type of credit are debts like mortgages and car notes, along with student and personal loans.
Revolving credit gives you two big advantages: a variable payment and credit replenishment as you pay down balances. Minimum payments are required, but beyond that it is up to you to decide how much to pay back each month and how long it takes to pay off the debt.
Installment loans are for a fixed amount of money that require a regular (usually monthly) payment for a certain period of time. Mortgages, for instance, can be of the 30-, 20- or 15-year variety. Car notes these days can go as long as seven years (not something I would recommend), but five years is pretty standard.
Installment credit vs. revolving credit
|Installment credit||Revolving credit|
|Types||Mortgage, student loan, car loan, personal loan||Credit card, home equity line of credit, personal line of credit|
|Payment terms||Fixed payment, usually monthly; interest rates often fixed, but can be variable||Minimum monthly payment; interest rates usually variable|
|Available credit||Fixed amount used to pay for a big purchase (such as a home or a car) or pay tuition; personal loans can be disbursed as a cash deposit and used at the borrower’s discretion (though some uses may be prohibited by lenders)||Determined by credit limit minus current balance|
|Credit score impact||Can initially lower your score via hard inquiry and decreased average age of accounts, but also raise your score over time through on-time payments, longer credit history and more diverse credit mix||Can initially lower your score via hard inquiry and decreased average age of accounts; can also lower your score any time balances are too high. Can eventually help your score via on-time payments, longer credit history and more diverse credit mix (if you have other types of trade lines).|
Personal loans can also be stretched out over five years but may also be for a shorter period of time (which I would recommend unless the terms involve a 0% interest rate).
The main difference is that with revolving credit you can keep borrowing and repaying and so on, seemingly forever.
For instance, if you have a credit card with a $2,000 limit, you can charge any amount up to that limit, pay it back and still have $2,000 to spend. Payments fund the amount of credit available to you that you can use again and again.
Let me caution you that under no circumstances would I ever suggest that you max out a credit card or line of credit. Remember that 30% of your FICO score is based on your credit utilization – how much of your available credit is being used. High utilization equals lower scores.
Revolving credit is available to you over and over again as you make repayments. Not so with installment loans. Once your installment loan is paid off, that’s it. Once you make a payment, your credit limit does not go back up.
How does an installment loan affect your credit score?
So, do installment loans have any bearing on that 30% for utilization in your credit score? Not directly.
There is a such thing as installment loan utilization, but it’s separate from revolving credit utilization, and it has a much smaller effect on your credit score. So if you’ve recently taken out a loan and have only scratched the surface with your monthly payments, your score should be just fine as long as your credit card balances are low. (Though a new loan could ding your score a bit due to a hard inquiry and a lower average age of accounts.)
One indirect way an installment loan can lower your revolving credit utilization ratio is to provide cash to pay off your credit card or other revolving debt. This can be especially helpful if you are over the 25% threshold on your credit card limits. The higher you go from there, the worse your score will be.
So, if you use an installment loan to pay down a credit card balance, you may see a significant increase in your credit score in a relatively short period of time.
If you take out a debt consolidation loan, be very sure that you can make your fixed payments on time. Also, you will now have credit cards with low or even zero balances, and you may be tempted to charge more and repeat the process. Resist this temptation while repaying the consolidated debt.
Use the cards, yes, but only for things that you have the cash on hand to pay for. This will enable you to keep your card benefits, like cash back, but stay out of debt. All of this will be great for your credit score and for your overall financial health.
See related: How often should you use your credit card?
A final word about installment credit. While it may seem like it doesn’t help you all that much in the short term, making those payments as agreed and on time each and every month is going to be reflected favorably in your score.
But what about once the house or the car or whatever is paid off? Does that mean all of those on-time payments no longer work in your favor? While it is true that your credit report will no longer show an active loan once it is paid off, that good loan history will stay on your credit report for at least 10 years. And that is a good thing.
Remember to keep track of your score!