Do Installment Loans Build Credit? What To Know Before You Take One Out

Muhammad Ahmad

Do Installment Loans Build Credit? What You Should Know Before Taking One Out

A loan can be a useful tool to help cover the cost of important expenses that you cannot pay back with cash. A car, house, wedding, medical bills, or any other big ticket item can all be covered with a personal loan.

There are a lot of different categories of personal loans available to individuals. Often, the money you borrow is paid back in equal monthly installments - known as a personal installment loan. Installment loans also offer the advantage of building or improving your credit profile when managed responsibly.

The main points

Installment loans have set monthly installments.

Installment loans can help improve your credit score over time with regular payments.

Installment loans give you access to funds for a variety of major expenses.

How do installment loans build credit?

An installment loan is an amount of money that you pay back over a set period of time, usually two to five years for a traditional personal loan. The loan balance is repaid in regular, fixed monthly instalments plus interest and any associated fees.

When you open this type of account and make consistent payments, it can be good for your credit profile. There are several ways an installment loan can help improve your score, and if you stick to healthy habits, your score can go up in a matter of months.

Establishes Payment History

Perhaps the most valuable way an installment loan can help increase your credit score is by allowing you to develop a regular on-time payment history. Your credit score is calculated based on several factors, but your payment history is the most important.

"Thirty-five percent of your FICO score is your payment history. It's the single biggest factor," says Mike Sullivan, director of education for nonprofit financial advisory agency Take Charge America. “Although installment loans need regular payments, making them on time can improve your credit score.”

However, the key is to make your payments on time. This will ensure that the loan is a positive addition to your profile rather than a detrimental one.

Diversifying the credit mix

Installment loans can also improve your credit score by adding variety to your mix of accounts in your name. Having a variety of accounts and managing them well can give your score a slight bump. Diversification can include having revolving accounts, such as credit cards, and installment accounts, such as installment loans.

"Credit mix as a percentage of credit score 10. Although it's not the most important factor in a credit score, it does play a role," says Freddie Haven, former vice president of data optimization at Freedom Debt Relief. "For lenders, it provides an indication of how they manage various loans and lines of credit, giving them an idea of how risky your lending is."

While having a variety of accounts can help your credit score somewhat, it is also possible to build or maintain a strong credit score with only one type of account, such as credit cards.

Reduces the overall use of credit

You can also improve your credit score when you use an installment loan to pay off credit card balances or consolidate debt. Increasing your score in this case will pay off credit card balances with debt and lower your overall credit utilization ratio.

The credit utilization ratio is the amount of revolving credit you use relative to the total revolving credit you have available. This is another important factor when calculating your credit score, as it makes up 30 percent of your total score.

The use of installment loans to repay credit cards or other regular debts can actually boost your credit rating by reducing the amount of the regular account and raising the amount of the installment account and that doesn't have the same effect on your credit use, Sullivan says.

How can installment loans damage credit?

As with any type of debt, paying off your debt and managing it responsibly is key. When not managed responsibly, installment loans can have a long-term negative impact on your credit score.

Loan payments missed

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. It can be hard to say how much damage it will do to your score, because everyone's financial picture is a little different.

If you miss a payment or make a late payment, this will be reflected in your credit history and negatively affect your credit score, says Huynh.

In addition, applying for a loan also slightly lowers your credit score. This is because difficult credit inquiries, which are usually required to establish credit, lower your credit score. While you usually have a short period where you can apply for several of the same type of loan at once — such as a car loan — without affecting your credit, you can apply for multiple types of loans close together. You should avoid applying for credit.

Lots of debt

Accepting any new debt increases your overall debt load and the new account can negatively affect your score. If you have a lot of debt, it will affect the "amount due" portion of your credit score, which makes up 30 percent of your FICO credit score.

For example, if you already have a mortgage, student loan, auto loan, and credit card debt, adding debt in installments can increase your debt-to-income (DTI) ratio. If your DTI is too high, lenders are less likely to consider you because it will put undue pressure on your budget.

Other ways to help your credit

While the best way to establish and maintain good credit is to use credit wisely and responsibly, there are other options besides installment loans that can help you actively build or improve your score. maybe.

Increase your available credit limits: 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 borrow a fixed amount — such as $500 — from and to. Although the annual interest rate may be higher, 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 backed by collateral. If the borrower defaults, the lender can take back the collateral, making these loans less risky for the lenders.

Pay all bills on time: By consistently paying all of your bills when they are due and doing so over the years, you will create a solid track record and history for managing and paying off debt responsibly. Payment history is the single most important element influencing your credit score.

If necessary, borrow only in installments

Installment loans can be a valuable financing tool to help cover important expenses. And when you pay responsibly, it can help build or improve your credit score. The most valuable way that installment loans can affect your score is by allowing you to establish a track record of consistent on-time payments.

However, taking out a loan as a credit building tool may not be the wisest decision. There are other less risky ways to improve your credit score without borrowing large amounts of money. One of the easiest strategies is to use a credit card for routine everyday purchases, pay off the balance in full each month, and pay on time.

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