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

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 your loan.

Using installment loans to 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, 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.”

Lenders commonly use the FICO model to judge creditworthiness. Managing an installment loan well has similar effects under other credit models.

One way to consistently pay on time is signing up for autopay. This will ensure 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.

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

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.

If you have good or excellent credit, you could also save money on interest. 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 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.

Typically, the higher your score, the lower it will fall when you miss a payment. This negative mark can stay on your credit report for up to seven years.

The lender could charge you late fees and pay more interest when you apply for future credit products. 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. myFICO states this drop is typically under five points per inquiry

If you apply with multiple lenders within the span of a few weeks, you should only see a single ding to your credit. FICO recognizes that borrowers commonly “shop” for rates. However, 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. 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.

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 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 them by their due date over many months, 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. These include utility bills, streaming service subscriptions, your phone bill and cable bill, among others.

The 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.