Do installment loans build credit? Yes — here’s how

It is possible for installment loans to build credit although there may be a small dip in your score when you first take out the loan. Over time, regular payments help you establish a positive payment history, but missed payments can have the opposite effect, depending on how you manage your loan.

This means that the impact on your credit is largely based on your actions, and you can improve your credit score with an installment loan, the same as with a mortgage or auto loan.

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Installment loan vs. revolving credit: What’s the difference?

Both forms of debt often show up on credit reports and impact your credit score, but there are some key differences between the two to be aware of.

An installment loan is borrowed money that you pay back over a specified period of time. The loan balance is repaid in regular, fixed monthly installments with interest and fees. Common types of installment loans include personal loans, student loans, auto loans and mortgages.

Revolving credit lets you access funds up to a certain limit. The latter replenishes as you make payments, and you’re free to reuse the funds as you see fit until the account closes. You only pay interest on the funds you borrow, and payments fluctuate since interest rates are typically variable on these debt products. The most popular types of revolving credit are credit cards and personal lines of credit.

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5 Factors that make up your FICO credit score

Before diving into the specifics of how installment loans build credit, it’s worth understanding what goes into your credit score. FICO is the most prevalent model, as it’s used by over 90 percent of creditors to make lending decisions.

Here’s a breakdown of how FICO scores are calculated:

1. Payment history (35 percent): It is the largest component of your credit score and shows if you’ve made timely payments over time.
2. Amounts owed (30 percent): This component of your FICO score represents the percentage of your credit limit in use, primarily on revolving debt accounts.
3. Length of credit history (15 percent): It accounts for the period of time you’ve had credit – the longer, the better.
4. Credit mix (10 percent): A solid mix of both revolving and installment credit is good news for your credit score.
5. New credit (10 percent): This section considers the number of new accounts and how long ago they were opened.

3 Ways installment loans can build credit

There are several ways an installment loan can help improve your credit score in a matter of months, largely by establishing a positive payment history.

1. Establishes payment history

According to personal finance consultant Mike Sullivan, the “single largest factor” in a FICO score is your payment record, which makes up 35 percent of your score. “Because installment loans require regular payments, on-time performance will enhance your score,” he says. By making regular, on-time payments, you will develop a positive payment history.

One way to consistently pay on time is by signing up for automatic payments. This will ensure your payment is always submitted by your due date. Some lenders even offer an interest rate discount when you select this option.

2. Creates variety in credit mix

You can use installment loans to build credit by diversifying or adding variety to the mix of accounts in your name. This mix can include revolving credit accounts like credit cards and installment accounts like personal 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, CEO and co-founder of Delos Financial Technologies. “For example, in this day and age where credit cards are relatively easy to obtain, data has consistently shown that consumers who do not have any credit cards at all are riskier than those who have some credit cards.”

3. Decreases overall credit utilization

Your credit utilization ratio is the amount of revolving credit you use relative to your total available revolving credit. This is another significant factor when calculating your credit score, accounting for 30 percent of your overall score. Sullivan says that installment accounts have less of an impact on your credit utilization than revolving ones:

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.

Debt consolidation loans are a type of installment loan used for paying off and combining unsecured debt, including credit cards. This kind of loan may make your debt more manageable by streamlining multiple accounts into one.

This approach should only be considered if you have a solid credit rating and can qualify for a loan with better terms than you currently have on the debt products you’re looking to consolidate. It’s equally important to stop using the credit cards once the balances are consolidated or you risk digging an even bigger debt hole.

3 Ways installment loans can hurt credit

When not managed responsibly, an installment loan can have a lasting, negative effect on your credit score. Missing payments and taking on too much debt may make maintaining a good credit score much more difficult.

1. Missed payments

Just as a history of on-time payments can drive up your credit score, missing or late payments can hurt it. “If you miss a payment or are late with a payment, it could appear on your credit report and could factor negatively into your credit score,” Huynh says.

This negative mark does not fall off your credit report for up to seven years. The lender could also charge you late fees and pay more interest when you apply for future credit products. Overall, you’ll be seen as a riskier borrower.

2. 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, can temporarily lower your score. According to myFICO, this drop is typically under five points per inquiry.

Depending on the type of loan, you may only see a single inquiry on your credit report when you apply. Credit scores take into account the fact that borrowers commonly shop for rates.

3. Too much debt

Taking on any new debt adds to your overall debt load. 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 is the second-largest component of your FICO score.

Adding an installment loan will also increase your debt-to-income (DTI) ratio. Lenders will be less likely to consider you if taking on a new loan will bring your DTI above around 36 percent since the new payment may strain your budget.

7 Tips for managing installment loans while building credit

You can build your credit with an installment loan by limiting how much you borrow, selecting a shorter term and – most importantly – making on-time payments.

1. Limit what you borrow: You may end up qualifying for more than you originally intended. While it may be tempting, borrowing more means a heavier debt burden that you will have to manage later. Instead, stick to what you need to make repayment easier.
2. Select a shorter term: A shorter term can save you money over the long run. While it may mean slightly higher monthly payments, you will be paying down more of the principal instead of interest.
3. Make timely payments: Late payments can negatively impact your payment history and lower your credit score. Instead, sign up for autopay or create reminders to help you stay on top of payment deadlines so you don’t risk damage to your credit score.
4. Watch your credit report: Mistakes do happen, so you want to be sure that your credit report is not being negatively impacted by incorrect information or false debt. Monitor your credit report regularly to ensure it remains up to date and accurate.
5. Create a monthly budget: It’s vital to stay on track with monthly loan payments. If you don’t already have one, create a realistic spending plan and make adjustments to your current expenses if needed to ensure you’re able to make timely loan payments.
6. Pay more than the minimum (if possible): If you can afford to pay a little extra each month, you will reach the finish line faster and free up wiggle room in your budget. Be sure the lender doesn’t charge prepayment fees since the cost of an early payoff could easily outweigh the benefits.
7. Keep track of your loan balance: Lenders provide amortization schedules when you take out installment loans, but you want to read your monthly statements to track your progress. Confirm the monthly payments are applied correctly to make sure it reflects the amortization schedule.

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Other ways to build credit

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

• Increase your available credit limit: Increasing your total available credit without actually using that credit will decrease your credit utilization ratio. This can be done by applying for a new card or by requesting an increase on a current card.
• Secured credit cards: These credit cards allow you to put up a set amount of money and then 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: Like auto loans, secured 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 your bills on time: By consistently paying your bills on their due date, you will establish a solid track record and a 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. These include utility bills, streaming service subscriptions, your phone bill and cable bill, among others.

Bottom line

Installment loans can be a valuable financial tool to help cover significant expenses. When repaid responsibly, they 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 wise. Other less risky ways exist to improve your credit score without borrowing large sums of money. One of the easiest ways is using a form of revolving credit, like a secured credit card, for routine daily purchases and paying the balance in full and on time each month.