60% of Americans do not have enough in their savings accounts to handle a $1,000 expense.
This is thanks to a range of factors including a lagging wage growth against rising costs of education, housing, and utilities.
Faced with an emergency or the need to purchase a big ticket item, Americans turn to credit.
For those with poor credit scores, access to certain credit facilities can be difficult. Not so with installment credit. This form of credit can actually help you improve your credit score.
Here is everything you need to know about this facility.
What Does This Credit Facility Entail?
This form of credit offers the borrower a fixed amount of money. The borrower then commits to making a set number of monthly payments on a specified dollar amount.
This loan facility can have a repayment period lasting from months to years until it’s paid off.
The loan limits typically range from between $500 to $5000.
Installment Loans vs. Revolving Loans
With this loan, you borrow a fixed amount of money and repay it in installments. If you need another loan, you apply for it separately.
Revolving loans are different. With a revolving loan, you can continue to borrow from a line of credit.
Here, you have a maximum amount of credit that is available to you at one time. You can keep borrowing, as you pay interest on what you owe until you hit your maximum limit.
When you reach your limit, you need to pay off some of the debt to free up your credit line and borrow again.
A credit card is a perfect example of this. Your card has an allowable limit you can borrow, as you repay. And as long as you are within this limit, you can borrow multiple times.
Types of Installment Loans
There are different types of installment loans. Let’s look at the most common ones.
This allows you to offset the borrowed amount within a number of years. Typically, the period is 15 to 30 years.
Once all payments have been made, you fully own your house.
Some mortgages come with fixed interest rates. This means the standard monthly principal and the chargeable interest does not change for the duration of the loan.
With a student loan, you get a specific amount of money to cater to your educational costs.
These at times come with a feature that allows you to defer payments until you find a job and start making an income.
Most people do not have enough saved up to allow them to pay for their cars in cash.
This necessitates the need for a car loan.
This loan is considered to be secured because, in the event that you default, your financier can repossess the car and recoup the loaned amount.
This is a type of loan where you can use the loaned cash to pay off sudden expenses or even to consolidate prior loans.
These are repayable in 12 to 96 months and attract higher interest rates than other loans. The reason they attract higher interest rates is that they are unsecured and therefore, risky for the lender.
What Do Lenders Consider Before Approving an Installment Loan?
For a lender to advance a loan, they need assurance that the money will be paid back in full. Here are a few considerations used to determine your creditworthiness.
The lender wants to evaluate how likely you are to repay the loan advanced to you.
They do this by looking at your previous repayment history.
While the credit score stipulations vary from lender to lender, typically you need a score of 670 and above for your loan application to be approved.
Most loans in this category have collateral requirements that help protect the bank form defaulters.
In most cases, the asset you intend to buy is also the collateral. If you apply for a mortgage, the house becomes the collateral. If you apply for an auto loan, the car you buy becomes the collateral.
Student loans are unsecured, but the bank is protected by a prohibition against student loan borrowers to file for bankruptcy.
Debt to Income Ratio
Your debt to income ratio is the percentage of your income that goes towards paying existing debt.
If too much of your income is going towards servicing debts, the assumption is that advancing you more debt becomes even more strenuous.
This makes you a high-risk borrower, meaning you have higher chances of defaulting.
Believe it or not, there are certain occupations that banks prefer. Government and PSU employees top this list.
The self-employed are lower down the list, and doctors, lawyers and blue-chip employees somewhere in between.
Aside from your field of occupation, your career history plays a role as well. If you tend to stick with one reliable employer over reasonable amounts of time, you are likelier to have your loan approved.
People aged 35-50 are more preferred. They are assumed to be at their financial prime and have a good number of working years left. This makes them more likely to be able to repay their loans.
On the flip side, borrowers over 65 years of age are considered to be risky borrowers in banks’ internal scoring models.
Financiers love it if you have a healthy surplus leftover after you pay your EMI’s. A low surplus suggested stretched finances, which makes you a high-risk applicant.
Additional considerations that come into play include the purpose of the loan. Environmental and economic factors can also factor into the lenders’ decision.
Other factors, like additional income streams, come into play. If you have multiple income streams, the banks are likely to view your application more favorably.
How Do Installment Loans Affect Your Credit Score?
Your credit score is a three-digit number that speaks on how likely you are to repay a debt.
Financiers use this figure when determining whether or not to advance a credit facility to you.
To understand how these loans help to build your credit, you must first understand how credit scores are calculated.
There are three primary credit bureaus in the US: Experian, TransUnion, and Equifax. These bureaus create your credit reports based on scoring models like FICO and VantageScore to score you on a scale of 300 to 850.
This score is typically based on your previous repayment history, information like race, religion, gender and so on are not factored in this scoring.
Some of the shared considerations in determining credit scores on both FICO and VantageScore are:
- Your payment history
- The types of credit you have, your credit limits and how much of it you are using
- How much debt you have
- Any defaults
The stronger your score is, the higher the likelihood of getting your loan approved, and vice versa. Also, the higher your score is, the higher the amount a financier is willing to lend you.
So how does this loan type affect your credit?
You Pay on Time
These loans reflect well if you make your payments on time. It does not stop there, however. Your lender has to report this information to the one or more of the credit reference bureaus.
Because timely payments are a huge part of your credit score, making timely payments will go along way in improving your current score.
On the flipside, payments that are 30 days late, or more will negatively affect your score. Having your car repossessed or your home in foreclosure is disastrous to your credit rating.
If you do take a loan partly aiming to improve your score, the main goal will be to make early, or timely payments.
If these are the types of things you tend to forget, you can have payments done from your account automatically by instituting a standing order.
You Only Have Credit Card Debt
If your current credit is limited to credit card debt alone, these loans can diversify your modes of credit.
This can give your score a slight increase. This is off course only possible if you make timely repayments on all types of credit you take on.
Credit Utilization Drops
Your score can also benefit from taking this loan to pay off your credit card debt.
This is achievable because offsetting your credit card debt reduces your credit card utilization ration.
Utilization simply refers to the amount of credit you maintain unused, Vis a vie the credit limit availed to you.
Aside from your repayment history, your credit utilization history is yet another key factor in determining your credit score.
Keep in mind, however, that applying for credit can lower your score lightly. This is effected by the lender carrying out a credit check on you. This check is known as a hard inquiry or a hard pull.
The other kind is a soft inquiry or a soft pull.
Hard Pull vs. Soft Pull
A soft pull is less intrusive, can happen without your consent, and has no implications to your credit score.
Not so for a hard pull. This search is most often triggered when you apply for a line of credit. You will likely find out about it because the lending institution is required to get your consent.
A hard inquiry shaves off five points off of your credit score. In addition, this becomes part of your record, and anyone prompting a soft pull also gets to view it.
As such, it is not usually advisable to take an installment loan just to improve your credit scoring.
This is unless you take a specific facility known as a credit builder loan. When you have a weak or inadequate credit history, this type of loan can help build it up.
With a credit builder loan, your loan is approved, but the cash is not given you. Instead, it is placed in a savings account.
You then make ‘repayments’ against this amount, which is when the deposited cash is disbursed into your account. At which point you can use it as you please.
You have to treat this as you should an actual loan, making late payments will negatively impact your credit score.
Advantages and Disadvantages of Installment Credit
Like any other credit facility, this type of loans comes with its own set of advantages and disadvantages
One advantage is predictable payments. This allows you to incorporate loan payments into your budget.
This also ensures your loan is cleared in a specific period of time, which is also good to know.
In as much as you are able to, pick the shortest loan term you can comfortably afford. This makes your facility cheaper by lowering the applicable interest.
On the other hand, this loan has its drawbacks when compared to credit card loan. With this facility, you can only get a fixed amount and no more can be advanced to you unless you make a separate application.
Again, your credit score might be used to calculate your interest. If you have had some challenges with your credit rating in the past, you will likely end up with a relatively high interest rate.
Besides the interest, the loan facility can also come with application fees and penalties making it even more expensive.
You can, however, avoid some of these by identifying a good lender, and by sticking to all terms of your contract.
Are You in a Financial Pinch?
If you find yourself in a financial pinch, installment credit might be your only option.
However, you need to remember that all lenders are not equal. You will want to look a credible lender with low application fees and one that offers you the lowest interest rates in the market.
Once the facility is advanced to you, ensure to pay special attention to the repayment plan. Key among all, the repayment dates. Ensure to make each payment of your installment loan on time, if not early.
Bonsai finance can help you better with your financial situation. We provide insights and give advices to enable our customers to achieve their financial goals. Talk to us today if you need a little help.
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