How Installment Loans Can Help You Build Credit

Establishing and building credit is crucial for financial health Having good credit means you’ll have more options when it comes to loans, credit cards, mortgages, rental applications, and more. One way to build credit is through an installment loan

What is an Installment Loan?

An installment loan is a fixed loan that is repaid in equal monthly amounts over a set period of time Examples of installment loans are auto loans, personal loans, and mortgages

With an installment loan:

• You borrow a lump sum of money upfront
• The loan amount plus interest is divided into equal monthly payments
• You repay the loan by making the same payment each month until it’s fully paid off

Installment loans are different from revolving credit like credit cards where the payment amounts fluctuate each month.

How Do Installment Loans Help Build Credit?

There are a few key ways that taking out and repaying an installment loan can help build your credit:

1. Establish a Credit History

If you have no credit history, an installment loan can help establish one. Before a lender will approve you for a loan, they’ll check your credit report to see if you have any existing credit accounts and your history of managing credit.

By taking out your first installment loan, like an auto loan or personal loan, you’ll establish a credit history. As long as you make your payments on time, this will start generating positive information on your credit reports.

2. Demonstrate Responsible Payment Behavior

The biggest factor in your credit scores is your track record of on-time payments. When you take out an installment loan, you agree to make regular payments of a fixed amount by a set due date each month.

As the loan issuer reports your positive payment activity to the credit bureaus, this shows you can responsibly manage installment credit. Paying late or missing payments can significantly hurt your credit score.

3. Improve Credit Mix

Credit scoring models like FICO look at your credit mix, which is the different types of credit accounts you have.

If you only have credit card accounts, getting an installment loan like an auto loan adds diversity to your credit mix. Having both revolving (credit cards) and installment (fixed loans) accounts can benefit your scores.

4. Lower Credit Utilization Ratio

Your credit utilization ratio compares how much you currently owe across all cards to the total credit limits you have available.

Using too much of your total credit limits can negatively impact your credit scores. When you pay off credit card debt by taking out an installment loan, this typically lowers your overall credit utilization which can boost your scores.

Top Ways Installment Loans Build Credit

• Establish credit history
• Show responsible payment habits
• Add account diversity with installment credit
• Lower overall credit utilization

What Makes a Good Installment Loan for Building Credit?

If you’re going to take out an installment loan to build credit, you want to make sure it’s structured in a way to benefit your credit, not hurt it. Here are some key features to look for:

• Affordable payments – Make sure the monthly payment works with your budget. Too high of a payment could lead to missed or late payments which damages credit.

• Fixed interest rate – Your rate stays the same over the full loan term so your monthly payment is predictable.

• No prepayment penalties – Gives you flexibility to pay off the loan early with no penalty.

• Reports to all three credit bureaus – Ensure positive payment info gets added to your Equifax, Experian, and TransUnion credit reports.

• No origination fees – Avoid fees just to take out the loan which add to your total repayment costs.

Types of Installment Loans for Building Credit

There are several common installment loan options to consider using specifically to build credit:

Credit-Builder Loans

With a credit-builder loan, the loan amount is deposited into a savings account while you make monthly payments. Once paid off, you get access to the deposited funds. Credit-builder loans are designed to help establish and improve credit history.

Secured Personal Loans

A secured loan requires an asset like cash or a vehicle as collateral that’s forfeited if you default. The lender’s lower risk means improved approval odds for those with poor credit. Make timely payments to build credit. Just be cautious borrowing against assets.

Co-signer Loans

If your credit is still developing, having someone with good credit co-sign the loan with you can help with approval. As long as you make the payments, it builds your credit history. But the co-signer is also on the hook if you default.

Auto Loans

Taking out a loan for a new or used car provides the installment credit needed to build a strong payment history. Just be careful not to take on more car payment than your budget can comfortably handle.

How Much Does an Installment Loan Help Credit?

How much your credit scores go up from an installment loan varies widely depending on your specific credit situation. In FICO’s own research on installment loans and credit:

• For those with no prior installment loan, scores increased as much as 21 points on average.
• People with no recent late payments saw an average increase of 19 points.
• Those with credit scores under 620 at the start saw an average increase of 29 points.

The impact is lower the stronger your credit already is. But for those with limited credit history and low scores, installment loans can provide a significant boost as long as payments are made responsibly.

Tips for Using Installment Loans to Build Credit

If you’re taking out an installment loan for credit-building purposes, make sure you leverage it effectively:

• Shop rates – Compare loan rates and terms across multiple lenders to get the best deal. Too many applications can dent your score temporarily.

• Make payments on time – Set up autopay or reminders to avoid missed payments that severely hurt your credit building progress.

• Pay down balances – Work to pay down revolving balances to lower credit utilization and maximize score improvement.

• Review credit reports – Check reports regularly to ensure positive payment info is being accurately reported by the lender.

• Consider adding a co-signer – If credit is poor, having someone with good credit co-sign can help with approval odds but puts their credit on the line too.

• Start small – Don’t take on more installment loan debt than you can handle just to build credit. Start with a manageable monthly payment.

The Downsides of Using Installment Loans for Building Credit

While installment loans can certainly help build credit, there are some potential risks to consider:

• Taking on more debt than you can afford making it hard to pay on time
• Paying interest costs just for credit building
• Putting up an asset as collateral that could be seized
• Harming credit if payments are late or missed
• Becoming too reliant on credit vs savings to make major purchases
• Getting stuck in debt if loan terms aren’t clearly understood

For these reasons, you generally want to use installment loans cautiously and strategically if building credit is your primary goal.

When Do Installment Loans Not Help Build Credit?

In certain situations, installment loans either won’t build credit at all or the impact will be reduced:

• Lender doesn’t report payments – If the loan issuer doesn’t report your payment history to the credit bureaus, it doesn’t affect your actual credit reports or scores.

• Loan is in someone else’s name – Being an authorized user on a loan may help a spouse build credit but typically not the primary borrower.

• You default on the loan – Defaulting on the loan results in serious damage to credit rather than building it.

• Payments are inconsistent – Sporadic on-time payments mixed with many late or missed payments limits credit building.

Unless payments are reported to the credit bureaus and made reliably on time every month, installment loans generally won’t help build credit effectively.

Alternatives for Building Credit Without Loans

If you don’t want to take on personal loan debt strictly for building credit, there are other options to consider:

• Become an authorized user on someone’s credit card if they have good credit and will report your activity to the bureaus. Make sure payments are always on time.

• Open a secured credit card, which requires a refundable security deposit that becomes your credit limit. Use lightly and pay off each month.

• Sign up for Experian Boost or UltraFICO to have positive payment histories for utilities, phone bills, streaming services, etc. added to your credit reports.

• Use a credit-builder service where you pay money into an account monthly and they report “loan” payments to the bureaus. The money is yours after.

• Apply for retail credit cards with low credit limits and manage carefully. Department store cards tend to be easier to get approved for.

These options let you demonstrate responsible credit management without taking out actual loans. However, they tend to have less dramatic impact on credit scores than installment loans repaid over months or years.

Summary