Do installment loans build credit? What you need to know before you take one out

Installment loans can make significant expenses more affordable by breaking the full amount into smaller monthly payments. A car, a wedding, an unexpected medical procedure and other major things can all be financed with this type of loan.

Being a type of credit product, installment loans affect your credit score. This impact can be positive or negative depending on how you manage this account.

How an installment loan can build credit

There are a few ways an installment loan can help improve your credit score in just a few months.

Establishes payment history

Perhaps the most valuable way that installment loans can help improve your credit score is by helping you develop a history of making regular, on-time payments.

“Thirty-five percent of your FICO score is your payment record. This is the biggest factor,” says Mike Sullivan, education director at Take Charge America, a nonprofit financial advice organization. “Because installment loans require regular payments, on-time performance will improve your score.”

One way to stay consistent with your payments is to sign up for autopay. This way you can be sure that your payment is always received on the due date. Some lenders offer a rate discount if you select this option.

Diversifies the credit mix

Installment loans can also improve your credit score by diversifying or adding variety to the mix of accounts in your name. This mix can include revolving accounts, such as credit cards, and installment accounts, such as loans.

“The credit mix makes up 10 percent of the credit score. While this is not the most important element in credit scoring, it does play a role,” said Freddie Huynh, former vice president of data optimization at Freedom Debt Relief. “For lenders, it gives an indication of how you manage different loans and lines of credit, giving them a better idea of ​​how risky a loan may be for you.”

While having different account types can help your credit score to some extent, it is also possible to build or maintain a solid credit score with just one type of account, such as credit cards.

Reduces overall credit utilization

The credit utilization ratio is the amount of your revolving credit that you use in relation to your total available revolving credit. This is another important factor in calculating your credit score, accounting for 30 percent of your total score.

“If an installment loan is taken out for the purpose of paying off credit cards or other revolving debts, it can actually improve your credit rating by removing the balance from a revolving account and adding an installment account, which does not have the same impact on your credit rating . use,” says Sullivan.

Debt consolidation loans are a type of installment loan used specifically for paying off and consolidating unsecured debts. In addition to the prospect of improving your credit utilization ratio, this type of loan can make your debt more manageable by streamlining multiple accounts into a single one.

If you have good or excellent credit, you can also save money on interest, as these loans offer a much lower interest rate than the average credit card.

How an installment loan can damage credit

If not managed responsibly, an installment loan can have a lasting, negative impact on your credit score.

Missed loan payments

Just as a history of on-time payments can boost your credit score, one or more missed or late payments can have a detrimental effect.

“If you miss a payment or are late on a payment, it will show up on your credit report and negatively impact your credit scores,” says Huynh.

Although it can be difficult to determine exactly how much this will hurt your score, as everyone’s financial picture is slightly different. This negative number can drag down your score for up to seven years.

The lender may charge you late fees and pay more interest when you apply for future credit products because you will be seen as a riskier borrower.

Hard credit applications

Applying for any type of loan can cause a slight drop in your credit score. This is because hard credit inquiries, which are typically required to obtain a loan, lower your credit score by up to 10 points.

Although you are usually given a short period in which you can apply for multiple loans of the same type at the same time (such as a car loan) without affecting your credit rating, you should avoid applying for multiple types of loans close to each other.

Too much debt

Taking on new debt adds to your overall debt burden, and the new bill can negatively impact your score. Having too much debt will affect the “amounts owed” portion of your credit score, which makes up 30 percent of a FICO credit score.

For example, if you already have a mortgage, student loans, a car loan, and credit card debt, adding an installment loan can increase your debt-to-income ratio (DTI). Lenders will be less likely to consider you if your DTI is too high as it will put unnecessary strain on your budget.

Learn more: Alternatives to installment loans

Other Ways to Help Your Credit

In addition to an installment loan, there are other options that can help you actively build or improve your score.

• Increase your available lines of credit: Increasing your total available credit without actually using that credit will lower your credit utilization ratio.
• Secured credit cards: Secured credit cards allow you to put down a fixed amount, such as $500, and borrow against it. Although the APR may be high, you may be able to avoid annual fees and build your credit as you borrow and repay.
• Secured loans: Secured loans, like car loans, are installment loans with collateral. If the borrower defaults, the lender can repossess the collateral, making these loans less risky for the lenders.
• Pay All Bills on Time: By consistently paying all your bills by the due date for years to come, you will build a solid track record of managing and repaying debt responsibly. Payment history is the biggest factor contributing to your credit score.
• Report your bills: Services like ExperianBoost can help you improve your credit score by reporting bills that aren’t normally reported to the credit bureaus, but that you still have to pay every month. These include utility bills, subscriptions to streaming services, your phone bill and cable bill.

Only take out an installment loan if necessary

Installment loans can be a valuable financial tool to help cover significant expenses. And if repaid responsibly, it can help you build or improve your credit score. The most valuable way installment loans impact your score is by helping you build a track record of consistent, on-time payments.

However, taking out a loan solely as a tool to build credit may not be the wisest decision. There are other, less risky ways to improve your credit score without borrowing large sums of money. One of the easiest tactics is to use a credit card for routine daily purchases, paying the balance in full each month and making payments on time.