How to Build Your Credit
Do you know your credit score? Do you know how your credit score can affect your everyday life? In the journey to building your credit, not only do you need to understand the basics of your credit score, you need to understand how it is affected simply by the kind of loan you might decide to use.
In this series we are going to explore the basics of what a credit score is, reasons why having a good credit score is important, and tips for building a good score and avoiding mistakes that can harm your score.
Build Your Credit: Installment Loans Transcript
Part 3: Build Your Credit: Installment LoansVideo
Idaho Assistive Technology Project (IATP)
In the previous module you learned about credit and how it is affected by finance company loans. In this module we are going to learn about installment loans and how they can influence your score.
The last presentation discussed the problems with finance companies and why you may want to avoid those types of loans. In this presentation, we will talk about installment loans, what they are, and how they impact your credit.
Examples of installment loans are auto loans, student loans, home loans, and personal loans.
With installment loans, you borrow a large amount of money up front, then agree to make fixed monthly payments over a specific period of time in order to fully pay off the loan. For example, an auto loan of $15,000 with a 7% interest rate, would require monthly payments of $300 for five years to completely pay the loan off.
Using the example of a $15,000 auto loan, let’s see what a typical installment loan might do for your credit.
First, an installment loan is considered to be a good type of loan, and contributes to the 10% of your score that measures “Types of Credit Used.” Ideally you would have a mix of both installment and revolving loans to get the highest possible benefit from this credit score factor.
Even though a low interest installment loan is a good type of credit, in the first year the auto loan is open, it is considered “New Credit” and that 10% section of your credit score will drop slightly. The new account also negatively impacts the 15% which measures “Length of Credit History”; however, after the first year or two of payments on the installment loan, it will no longer be considered new credit, and will begin to reflect the benefits of a more mature account.
Keep in mind that to get the most benefit on the “Length of Credit History” factor, an account must be open and active for 10 years or more. In our auto loan example, the loan will be completely paid off in five years, and then will no longer be considered “active.” Since inactive and closed accounts do not contribute to your credit history, this 15% will not benefit much from most installment loans.
The “Payment History” factor is very simple with installment loans. Using our auto loan example, if you simply make all of your payments on time, this factor builds positive credit history. However, once the loan is paid in full, there is no longer any positive payment history being added.
Keep in mind that with any loan, only a few missed or late payments can result in a significant drop in your credit score. That’s because this is the biggest factor of all in a credit score. Making timely payments is the foundation to building a good credit score.
There are many consequences to late payments. The later the payment the more damage to your credit score. Once a payment is late by three to six months, it may be sold to a collection agency which will use harsher tactics to collect the debt owed. It is always important to make your payments on time for any type of loan.
Last, the 30% of your score that measures “Amounts Owed” takes a significant hit when an installment loan is first opened. This is because the beginning balance of an installment loan, like our auto loan example, is usually at the maximum balance, putting your debt ratio at 100%. The good news is that as you begin to pay the balance, the ratio gets lower and lower, which helps this portion of your score. Unfortunately this takes time, and once the account is paid off and closed, it no longer contributes recent activity to your score.
So with an installment loan, you get some benefit from this 30% section, but also some negative activity as well.
Slide 8: (Interactive)
[Question #1] An installment loan usually starts with what type of balance?
[Answer #1] An installment loan usually stars with a high balance.
[Question #2] Which of the following is a consequence of making late payments?
a. A drop in the “Payment History” section of your FICO score.
b. A drop in the “Amounts Owed” section of your FICO score.
c. Your account going to a collection agency.
d. Automatic closing of your account.
[Answer #2] The consequences of making late payments on an installment loan may include a drop in the "Payment History" and "Amounts Owed" sections of your FICO score and your account may be sent to a collection agency.
Installment loans are a much better choice than finance company loans for building and keeping a good credit score, but they still have their shortcomings. The major shortcomings with installment loans include their high initial debt ratio, and short loan periods.
Another major shortcoming besides those already mentioned, is that lenders usually only give installment loans to customers who have already established a decent credit score. If you have no or poor credit history, it can be very difficult to get any type of reputable installment loan.
Now you have learned about some possible pros and cons to having an installment loan for your credit score. This is a loan that people often need and if used properly can aid your score but this is not the best way to improve your credit score.
Thank you for watching this webinar. We hope you found it relevant and useful to your life.