An installment loan can help your credit in a big way, but only if you pay as agreed. It may also help in a small way by giving you a better credit mix if you only have credit cards.
Here’s what you need to know about the types of installment loans and how they can affect your credit score.
What are installment loans?
Installment loans have equal payments over a set period, then end when fully paid. There are two main types:
- Secured loans are made for something the lender could reclaim if the borrower doesn’t pay. Car loans and mortgages are examples. They tend to have lower interest rates because the lender can repossess the vehicle or foreclose on the home.
- Unsecured loans aren’t backed by anything a lender could reclaim, such as student loans and personal loans. They tend to have higher interest rates, reflecting the bigger risk to the lender.
Installment accounts are different from revolving credit, which usually means credit cards. For revolving accounts, payment amounts vary and there’s no set end date.
How do installment loans affect credit scores?
The biggest influence on credit scores is payment history. A record of on-time payments will help your credit — but late payments can cause serious damage to your score. And losing a home or car to foreclosure or repossession can devastate your credit.
You want to make sure your lender reports your account activity to the major credit reporting agencies, Equifax, Experian and TransUnion. If your on-time payments aren’t reported, they’re not going to help your credit score.
A smaller factor in scores is your account mix. If you only have credit cards, adding installment debt helps diversify your types of credit and might give you a modest bump.
How do personal loans for debt consolidation affect credit?
Taking out a personal loan to pay off high-interest credit card debt can help your credit in one more way.
Debt consolidation using a personal loan moves credit card debt onto an installment loan, which reduces your credit utilization ratio. Utilization is credit-speak for the amount of your balance relative to your limit. It’s another large factor in your credit score. Most experts recommend using less than 30 percent of each card’s credit limit, and less is better. Moving debt onto an installment personal loan can instantly reduce your per-card and overall utilization.
As a side benefit, moving credit card balances to a personal loan with a lower annual percentage rate can help you get out of debt more quickly.
Be sure you don’t accidentally hurt your credit in other ways:
- Don’t close down credit card accounts unless you have a compelling reason to do so, like an annual fee. The overall age of your accounts also figures into your credit score, and you can hurt it by closing old accounts.
- Resist the urge to spend more and run your credit card balances back up. That wipes out any gains you made by lowering utilization and adds to your debt load.
- Each application for credit can cause a small, temporary loss of a few points. Apply for loans only when you’re reasonably confident you’ll qualify.
Should you take out an installment loan just to build credit?
It’s usually unwise to take out an installment loan strictly to improve credit, but there’s one exception: credit-builder loans. As their name suggests, building credit is their whole reason for existing. When you have no credit or thin credit, these installment loans can help you build your credit profile.
Once a credit-builder loan is approved, the money is deposited in a savings account or certificate. The money is not released to you until you have paid off the loan.
Paying on time builds your credit history, and you have a nice emergency fund built up by the time you pay off the loan. But failing to pay on time hurts your credit, and borrowing too much could strain your budget and lead to missed payments.
Monitor your progress
As you build credit, you’ll want to watch your progress. You can check your credit score, as well as get a free credit report summary, updated weekly, from NerdWallet. In addition to tracking your score, you can monitor your credit utilization and other scoring factors.
Bev O’Shea is a staff writer at NerdWallet, a personal finance website. Email: firstname.lastname@example.org. Twitter: @BeverlyOShea.