Ways Installment Loans Could Help Improve Your Credit Score
Installment loans can help improve your credit because they can positively impact some of the key factors that go into calculating your credit score. Two primary things to recognize about installment loans are that they are a longer-term financial commitment, and their repayment must be managed successfully in order to return the benefits to your credit score. Here’s a look at a few main ways they relate to your credit.
What is an installment loan?
An installment loan is a loan that lets you borrow a lump sum of money and repay it with interest over a set time period. Auto loans, mortgage loans, personal loans and student loans are all common examples of installment loans.
Can installment loans help build your credit?
An installment loan could help build your credit — if it is managed wisely and the loan is reported to the three major credit bureaus. To understand how an installment loan affects a credit score, you have to know how credit scores are calculated.
Information in your credit files at the three main credit reporting companies — Equifax, Experian, and TransUnion — is used to calculate the two credit scoring models, your FICO Score and VantageScore. This information can be grouped into categories, but not every category carries the same weight in your score.
Here’s a quick look at how FICO and VantageScore weigh different factors when figuring a credit score.
FICO relies on five categories, measured by percentages in order of importance:
- Payment history: 35%
- Amounts you owe (how much credit you’re using): 30%
- Length of credit history: 15%
- New credit: 10%
- Credit mix: 10%
VantageScore relies on similar factors, but rates them by level of influence:
- Payment history: Extremely influential
- Duration of credit history and mix of credit: Highly influential
- Percentage of available credit you’ve used (credit utilization): Highly influential
- Total balances you owe: Moderately influential
- Recent credit inquiries and behavior: Less influential
- Available credit: Less influential
Installment loans can help improve your on-time payment history
As you can see, payment history is the most important factor of both FICO Scores and VantageScores. So, the importance of establishing a record of on-time payments can’t be overstated.
Because installment loans require planned payments over an extended period of time, they can give you a great opportunity to make regular on-time payments that will help you improve your score.
Diversifies your debt
A smaller but valuable part of your credit score gauges your credit mix, or the different types of credit and loans you have.
Maybe you have an established record of responsibly using only one type of credit, say, a credit card — which is a form of revolving credit. That’s great, but a credit mix that’s varied, such as a car loan and a credit card, demonstrates to lenders that you’re able to responsibly manage different types of credit over time.
Which affects your credit score more: installment loans or credit cards?
Both installment loans and credit cards allow you to borrow money that you will eventually repay. But their impact on your credit score may be a little different.
Why? Revolving credit is very influential when calculating your credit utilization rate, or the amount of your total credit limit that you’re using. Credit usage is among the top three factors that make up your credit score. Consider:
- When you pay the revolving balance on a credit card, the amount can vary depending on how much you charge month to month, and your credit score may rise as you’re freeing up more of your available credit.
- When you’re making monthly payments on an installment loan, the amount you pay stays the same.
Bottom line? Revolving debt may have more of an impact on credit scoring, because loan balances and the utilization rate (how much credit you’re using) are key factors in determining your credit score.
What are the potential risks of taking out an installment loan?
A potential risk of taking out an installment loan largely centers on your ability to consistently handle the monthly payments at the agreed-upon terms. An installment loan is a commitment that lasts the full length of the loan. So, while installment loans can be valuable financial tools to help build credit, it’s important to make sure the monthly installment loan amount fits easily into your monthly budget to avoid being overextended.
The influence of payment history on your credit score goes both ways: While paying on-time every month helps build a higher credit score, failing to make scheduled payments can lower it. What’s more, missing loan payments could also make it harder to open additional credit accounts or access additional funds through the accounts you already have.
For instance, taking out an installment loan could produce a temporary dip in your overall credit rating, simply because you’ve added new debt. Depending on your financial situation, this could make it harder to get approved to open another type of credit in the short term.
Lastly, it’s also vital to understand the difference between secured and unsecured loans because the risks are different. What may happen should your circumstances change and you’re no longer able to meet the payment terms?
If your installment loan is a secured loan, which requires an asset as collateral, you could be at risk of default and potential loss of the collateral used to secure the loan. An unsecured loan is not backed by an asset, which means there is no collateral. But if a loan is delinquent or in default, a lender will likely seek repayment by other means, or you may be able to work out other solutions.
Should you get an installment loan to help build credit?
You shouldn’t take out an installment loan strictly to improve credit. You should borrow money when doing so makes sense for your personal finances, money goals, and specific needs. Installment loans come with interest, so always carefully review the loan choices, interest rates, and loan term limits to get the most favorable options you can qualify for.
Installment loans are valuable financial tools to help meet bigger goals, such as buying a car or paying for education, or for consolidating debt in a lower-cost way. And because they can help demonstrate a reliable payment history and broaden credit mix, they can help your credit profile when you’re looking to strengthen it.
This content provided is for educational and informational purposes only and does not constitute financial or legal advice. RISE is not acting as a credit counseling or repair service, debt consolidation service, or credit services organization in providing this content. RISE makes no representation about the reliability or suitability of the information provided – any action you take based on this content is at your own risk.