Installment Loans vs. Credit Cards’ Effect on Bad Credit

There are two main types of credit, and both may affect your credit score in different ways. Here, we will examine installment loans and credit cards. What are they, how are they different, and what can you do if you have bad credit?

What’s the Difference?

First, it helps to define exactly what each type of credit is.

• Installment loan– a loan with a fixed number of specified payments, terms and interest.
• Credit card – a ‘revolving’ account with a maximum credit limit, a fluctuating minimum monthly payment, and the potential for varying interest rates.

How Are They Different?

An installment loan is repaid in agreed-upon specified installments, usually with the same amount every payment period. Sometimes, the last installment payment may differ because of additional fees or charges incurred or accrued as a result of late payments or non-payment. Mortgages and auto financing loans are types of conventional installment loans. Once the loan is repaid in full, the account is considered ‘closed’.

This is important because a ‘closed’ credit account in good standing may have a positive impact on your credit worthiness. Paying off an installment loan within the agreed amount of time positively impacts your credits.

Credit cards are different. Credit cards usually have a maximum credit limit that can be used on a ‘revolving’ basis. The actual amount that you have available to use at any given time is the difference between your credit limit and the amount you owe. You will need to meet the lender’s minimum payment requirements, but you can pay more if you want to.

A credit card account is called ‘revolving’ because: 

• it carries forward the balance of money owed from month to month
• it is an open-ended type of loan, with no fixed end date
• money that is repaid is available to borrow again
• the monthly payment varies (up or down) according to the balance owed

The biggest impact your credit card balance has on your credit worthiness is based on your utilization rate or balance-to-limit ratio. This is calculated by adding together the total of your credit card balances and then dividing by the total of your credit card limits.  For example: 

 Generally, the lower your utilization rate, the better your credit score. Banks typically consider an ideal credit utilization rate to be about 35%. The illustration above may be representative of a person to whom banks may not be willing to lend, but for whom short term installment loans may be available. There is nothing inherently good or bad about the utilization rate only in that it may matter when a lender is  determining whether to loan you the money you need.

What Difference Does This Make for Me?

It depends entirely on your needs. A credit card balance may ultimately cost you more in the long run, especially if you pay only the minimum payment.

It's also important to look at your motivation in pursuing a loan. Are you looking to improve your credit score, or are you caught in a financial emergency and need money fast? 

If you carry a several high credit card balances, you might consider taking out a conventional installment loan to pay them off. Such an installment loan could result in a higher credit score, both short-term and long-term, as well as a lower interest rate as you pay the loan off.

If you have an emergency expense that would only take a few pay periods to pay off, consider using a short term installment loan. As your budget allows, pay it off early in order to minimize the interest you pay toward the loan. Paying that emergency expense on time could help improve your credit score.

What are my options for loans with bad credit?

If you have bad credit, it is possible you may not be approved for a credit card. Your options may include:

• Short term installment loans
• Personal loan with a cosigner
• Payday loans
• Title loans for a vehicle
• Pawn shop loans

Short term installment loans may be available to consumers who have poor credit. Some options include unsecured personal loans or signature loans.  There is no cosigner or collateral needed. Therefore, the process to apply and receive money is fast. Since there is no collateral, short term installment loan applications may be done completely online, depending on the lender.  Depending on the lender’s practices, you may also need to contact them by phone to verify your personal information.

A personal loan with a cosigner is a conventional installment loan. You rely on the better credit of the person who is cosigning in order to receive more favorable terms.

The remaining options listed above, payday loans, title loans and pawn shop loans may require you to sign over a postdated check, bank account ACH access, your vehicle title or a valuable possession in order to secure the loan. Payday loans are due on your next payday. Title loans are often due in 30 days and pawn shop loans can be due in 30 days or up to a few months.

Short term installment loans are generally easy to get and easy to repay since they tend to span several months or more. The repayment schedule may be based on when you receive your paycheck, but is broken into multiple payments and spread out over time.