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 borrow. Over time, regular payments help you establish a positive payment history.

Depending on how you manage your loan, missed payments will have the opposite effect. This means that the impact on your credit is largely based on your actions, and you can improve your credit score with a personal loan just the same as a mortgage or auto loan.

What is an installment loan?

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.

Using installment loans to 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.

Establishes payment history

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

“Thirty-five percent of your FICO score is your payment record. This is the single largest factor,” says Mike Sullivan, a personal finance consultant with Take Charge America, a national nonprofit credit counseling and debt management agency. “Because installment loans require regular payments, on-time performance will enhance your score.”

One way to consistently pay on time is 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.

Diversifies 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.

He adds, “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.”

However, you can also build or maintain a solid credit score with just one type of account, such as credit cards. Don’t feel like you must take out loans you don’t need to increase your credit score.

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,” Sullivan explains.

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

How an installment loan 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.

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.

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. However, you should avoid applying for multiple types of credit close together, since each application may count as a single inquiry on your credit report.

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 makes up 30 percent of a FICO credit 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 about 36 percent. The new payment may strain your budget.

Learn more: Alternatives to installment loans

Tips for managing installment loans to build credit

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

• 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.
• 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.
• Make timely payments: Late payments can negatively impact your payment history, lowering 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.
• 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.

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: Secured 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: 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 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 is using a credit card for routine daily purchases and paying the balance in full and on time each month.