Do Installment Loans Help Build Credit?

An installment loan provides a borrower with a fixed sum of money, which is then repaid through scheduled, consistent payments over a predetermined period. Common examples include auto loans, mortgages, student loans, or personal loans. These loans differ from revolving credit, such as credit cards, where a borrower can repeatedly access funds up to a credit limit. A credit score serves as a numerical representation of an individual’s creditworthiness, indicating their likelihood of repaying borrowed funds.

Fundamentals of Credit Scoring

Credit scores are numerical assessments that help lenders evaluate a borrower’s financial reliability. While various scoring models exist, such as FICO and VantageScore, they assess similar aspects of an individual’s financial behavior. Both FICO and VantageScore models range from 300 to 850, with higher scores indicating lower risk to lenders. These models consider several key categories when determining a credit score:

Payment history: The most significant factor, accounting for approximately 35% of a FICO score and highly influencing VantageScore models. This reflects whether payments have been made on time.
Amounts owed (credit utilization): A major component, making up about 30% of a FICO score and highly influencing VantageScore. This assesses the proportion of available revolving credit being used.
Length of credit history: Contributes around 15% to a FICO score and highly influences VantageScore. This considers the age of accounts.
Credit mix: Represents the diversity of credit accounts, accounting for about 10% of a FICO score and highly influencing VantageScore. This includes a blend of revolving credit and installment loans.
New credit: Including recent applications and newly opened accounts, makes up the remaining 10% of a FICO score and is less influential for VantageScore.

Each time new credit is sought, a “hard inquiry” may temporarily lower a score.

The Role of Installment Loans in Credit Building

Installment loans can significantly contribute to building a positive credit history when managed responsibly. Consistently making on-time payments on an installment loan directly impacts the payment history component, which is the largest factor in credit scoring models. Each successful, timely payment demonstrates reliability, creating a pattern of responsible financial behavior that benefits the credit score.

Adding an installment loan to a credit profile can also improve the “credit mix” factor. If an individual primarily has revolving credit, such as credit cards, introducing an installment loan diversifies their credit portfolio. Lenders prefer to see a variety of credit types managed effectively, indicating an ability to handle different financial obligations. This diversification can positively influence the credit score, especially if only revolving credit was previously used.

For an installment loan to affect a credit score, the lender must report payment activity to the major credit bureaus: Experian, Equifax, and TransUnion. Most traditional installment loans, like mortgages and auto loans, are routinely reported. While applying for an installment loan may result in a temporary, small dip in the credit score due to a hard inquiry and the new account, consistent on-time payments typically lead to score improvement over time. The initial loan amount and its term should align with the individual’s financial capacity to ensure manageable payments.

Responsible Use for Credit Improvement

Utilizing an installment loan specifically for credit improvement requires careful planning and disciplined financial habits. The most important action is making all payments on time and in full. Late payments, especially those 30 days or more past due, can significantly damage a credit score and remain on a credit report for up to seven years. Setting up automatic payments can help ensure payments are consistently made by their due dates.

Choosing an installment loan with affordable payments is essential to prevent financial strain and the risk of missed payments. While borrowing can help build credit, it is prudent to avoid taking on excessive debt or too many loans simultaneously. Multiple hard inquiries from numerous loan applications within a short period, outside of typical rate shopping windows, can signal financial distress to lenders and potentially lower a score.

Regularly checking one’s credit report is another important practice to ensure that the installment loan activity is being accurately reported by lenders. Individuals are entitled to a free credit report from each of the three major bureaus annually. Reviewing these reports helps verify that payments are correctly recorded and that no errors are impacting the score. Focusing on responsible management of the installment loan, rather than solely on the score, will lead to sustainable credit improvement.