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

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

Because they’re a type of credit product, installment loans impact your credit. 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 a matter of months.

Establishes payment history

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

“Thirty-five percent of your FICO score is your payment record. This is the single largest factor,” says Mike Sullivan, Director of Education at the nonprofit financial counseling agency Take Charge America. “Because installment loans require regular payments, on-time performance will enhance your score.”

One way of staying consistent with your payments is by signing up for autopay. This will ensure that your payment is always submitted by your due date. Some lenders offer a rate discount when you select this option.

Diversifies 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, like credit cards and installment accounts, like loans.

“Credit mix makes up 10 percent of the credit score. While it’s not the most important element in credit scoring, it does play a part,” says Freddie Huynh, the former vice president of data optimization at Freedom Debt Relief. “For lenders, it provides an indication of how you manage different loans and lines of credit, which gives them more of an idea of how risky lending to you might be.”

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

Decreases overall credit utilization

Credit utilization ratio is the amount of your revolving credit you’re using relative to your total available revolving credit. This is another significant factor when your credit score is calculated, accounting for 30 percent of your overall score.

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

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

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

How an installment loan can hurt credit

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

Missed loan payments

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

“If you miss a payment or are late with a payment, it will appear on your credit report and factor negatively into your credit scores,” Huynh says.

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

You could be charged late fees by the lender and pay more on interest when you apply for future credit products, as you’ll be seen as a riskier borrower.

Hard credit inquiries

Applying for any type of loan can cause a slight dip in your credit score. This is because hard credit inquiries, typically required to establish a loan, draw down your credit score to 10 points.

While you usually get a short period where you can apply for several of the same type of loan at once — like an auto loan — without affecting your credit, you should avoid applying for several types of credit near each other.

Too much debt

Taking on any new debt adds to your overall debt load and the new account can negatively impact your score. If you have too much debt it will affect the “amounts owed” portion of your credit score, which makes up 30 percent of a FICO credit score.

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

Other ways to help your credit

There are other options beyond an installment loan that can help actively build or improve your score.

• Increase your available credit lines: Increasing your total available credit without actually using that credit will decrease your credit utilization ratio.
• Secured credit cards: Secured credit cards allow you to put up a set amount — like $500 — and borrow against it. While the APR can be high, you may be able to avoid annual fees and build your credit as you borrow and repay.
• Secured loans: Secured loans, like auto loans, are installment loans backed by collateral. If the borrower defaults, the lender can repossess the collateral, which makes these loans less risky for lenders.
• Pay all bills on time: By consistently paying all of your bills by their due date and doing this over years, you will establish a solid track record and history of managing and repaying debt responsibly. Payment history is the single biggest factor contributing to your credit score.
• Report your bills: Services like ExperianBoost, allow you to boost your credit score by reporting bills that aren’t normally reported to the credit bureaus but that you still have to pay each month. These include utility bills, streaming service subscriptions, your phone bill and cable bill, among others.

Only take out an installment loan if necessary

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

Taking out a loan simply as a credit building tool, however, may not be the wisest decision. Other, less risky ways exist 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 the payments on time.