If you’re thinking about buying a home in the next few years, there are a few things you should know about how different types of debt can affect your credit score. Some savvy financial planning can put you lightyears ahead when you’re applying for a mortgage down the road.
Installment loans (think auto loans, student loans, and mortgages) and revolving debt, like credit cards, can be used wisely to increase your credit score. The better your credit score, the easier it will be for you to get a mortgage and the more favorable terms you’ll get on that mortgage.
So, it’s worth your time to learn about how different types of debt can improve your credit score so that you’re ready to get a mortgage when the time comes.
How Debt Affects Your Credit Score
Your credit reports at the three national credit bureaus (Experian, Equifax, and TransUnion) are a record of your history with all the debt you’ve ever had. They document your payment history and the details of your loan.
Installment loans and revolving debt affect your credit score differently, but both can help you improve it over time. Different types of debt affect your credit score in slightly different ways.
An installment loan is when you borrow a certain amount of money and pay it back in installments over time. These payments are usually made on a monthly schedule and are most often the same amount each month. Mortgages, auto loans, student loans, and personal loans are all different kinds of installment loans.
How Installment Loans Can Improve Your Credit Score
If you have only credit cards, adding an installment loan like an auto or personal loan can actually improve your credit. Having a mix of debt types is preferable to having just one type of debt.
If you get an installment loan to pay off credit card debt, your score may actually improve. This is because moving credit card debt to an installment loan reduces your credit balance relative to your credit limit, which is a large factor in your credit score.
However, remember that these improvements are usually steady gains over time rather than sudden jumps in your score.
Installment Loan Tips
First, make all of your payments on time. If possible, set them up for auto payment so there’s no chance of missing them. Payment history is one of the biggest influencers on your credit score, so even one missed payment could cause a large drop.
Also, keep in mind that you might see a short-term reduction in your credit score when you first apply for and are approved for an installment loan. This is because the lender must make a hard inquiry on your credit, but it’s also because borrowers who take on new debt are more likely to default on their other loans. Just remember: your score will usually rebound within just a few months.
Last, if you’ll be applying for a loan before applying for a mortgage, it’s usually wise to space out the loan application process by six months to a year so that your credit scores can rebound between the first loan and the second.
Revolving debt includes credit cards and store cards that allow you to charge up to a certain amount on a revolving basis. Unlike installment loans, the amount you owe each month varies.
How Revolving Debt Can Improve Your Credit Score
If you’re not ready to get an installment loan, or if you don’t have much of a credit history, a credit card can put you on the fast track to establishing some. It’s a good way to show that you know how to manage debt without having to incur interest charges.
Revolving Debt Tips
First, you’ll want to keep your balance fairly low—around 30% of what you can borrow, according to most experts. This is your credit utilization ratio, and it’s an important factor in your score. You can’t max out your credit cards and have a good score.
Next, always pay on time. If you can, set up auto payment so that you’ll never miss a payment. If you want to avoid interest charges, pay off the statement balance in full each month.
If You’re Ready for the Next Step
If you want to do some more planning to make sure you’re ready to get a mortgage when the time comes, I hope you’ll give me a call! I’m here to explain the process and help make it easier for you.