Careful use of credit cards can improve your credit score, just by showing a history of timely payments and modest balances. But what can loans do for your score, and what do you have to do to get the most out of them?
Like credit cards, a great deal depends on your ability to manage loans correctly. Let’s look at the options and highlight some of the best practices for borrowers who want to take advantage of the flexibility that a loan can bring to their budget or next project. All the while, we'll outline the ways that loans stand to boost credit scores and cast the borrower in a responsible light.
Types of Loans: Credit Score Impact
To start with, here’s the bottom line: your payment history accounts for 35 percent of your credit score’s calculation. And loans should be a part of that.
Experts recommend a blend of revolving credit (such as credit cards) and installment credit — loans. This blend shows banks and other creditors that you can handle yourself in the real world, big ticket items and small.
And so, to expand your borrowing history responsibly, here’s a breakdown of some loan types and how they can have an impact on your credit score when you manage them well.
Basic Installment Loans
A home loan, an auto loan — these all stand to help your credit score, putting that strategy of an ideal mix into play. When you’re making a purchase for more than $1,000, these kinds of loans are usually the go-to example. Secured or unsecured, they can provide reasonable interest rates. But to reap credit-score benefits, you have to pay back your loan on time and you have to be careful of loan types. For example, taking a loan with a finance company to pay for a new flat-screen TV — rent-to-own, and other such services, for example — could put a ding in your score.
Future lenders will typically evaluate an auto loan for a new family vehicle more positively that one for something that looks like a luxury item. Beyond that, a key idea, according to Kurt Polzin, regional manager at Certified Credit Experts, is to manage the loan for a year or more. “Loans do more damage in the first 12 months than they do good,” Polzin says. “You are getting hit for the newness and the inquiry, and you do not have enough history to make up for it.” After a year or two of good payments, however, you’re sure to accumulate enough “bonus points” that you’ll make up for the initial drop. Note that FICO says its scores do reflect a difference between borrower activity while searching for a single loan and multiple tries for new credit lines — the length of time over which inquiries occur figures into the equation.
Secured Installment Loans
As long as you make the right payments, on time, your credit score should benefit from a secured installment loan. The key difference is that you’ve put up an asset or assets as a guarantee to the creditor. Just like other installment loans, the amount you’ve borrowed isn’t the issue — banks and other agencies assume you won’t pay it off in a month — it’s your record of on-time installments that affect the score.
Student loans are typically evaluated just like any other installment loan, except that they often come with five-figure balances (or higher). Students walking away from their senior year with $50,000+ on the books is perhaps the new normal. In any case, banks and other agencies tend to look at student loans as “good credit” — that is, an investment and not a luxury item. And recent research by Fair Isaac and Company (FICO, the organization that creates the algorithms that generate the credit scores most lenders use) shows that even the biggest borrowers can earn credit ratings in the 800s. So scores are not necessarily dipping because student loans are part of the individual’s credit blend. That being said, watch out, student-loan shoppers. Multiple inquiries as you try for different loans can cause a hit on your score (10 percent of your score is calculated by the number of inquiries that creditors make to your report). But, as with other loan types, paying your installments on time will have a greater impact in the positive category, in the long run.
These kinds of loans might seem inherently questionable, when it comes to affecting credit scores — they’re so often associated with an air of desperation — but the truth is that as long as you pay the lender back as agreed your score should remain untouched. Most short term loan outfits don’t even run a credit check, so your score won’t take the potential inquiry hit that other kinds of loans can incur.
And so, remember: the typical strategy for increasing your credit score includes loans. A blend of installment payments and revolving credit shows that you’re responsible and engaged in your own financial health.
Payment history is everything, of course. Also, you want to think about the long game -- a year or more of good payments stands to maximize the positive effect your loan will have on your score going forward.