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Installment loans can help improve your credit score by adding on-time payment history to your credit report. They can also broaden your credit mix, which is a credit score factor that considers the types of accounts you own, if you primarily used credit cards in the past.
It's important to remember, however, that getting an installment loan may not have an immediate or significant positive effect on your credit and may actually bring scores down in the short term. Responsible account management that includes making consistent, timely payments will promote steady, sustainable growth in your score over time.
Read on for more details about how an installment loan could potentially take your credit to the next level.
What Is an Installment Loan?
An installment loan is a type of credit that's paid off in fixed payments, usually on a monthly basis, over a set repayment term. Typically, unless you've received an intro 0% APR financing deal, you'll pay interest to the lender in exchange for paying off the loan over time. The loan can be either secured—that is, it's backed by a piece of collateral that the lender can take away if you don't pay—or unsecured. Common installment loans include mortgages, student loans, personal loans and car loans.
Installment loans are different from credit cards, which are a type of revolving credit. Unlike installment credit, a revolving credit account lets you repeatedly borrow money and pay it back over a period of time.
Whereas you might take out an installment loan for $10,000 and pay it back over five years, a credit card would provide you with a credit limit or credit line (for comparison's sake, say $10,000), which you could charge up to as you wish. You'll typically accrue interest on any balances you carry from one billing period to the next.
Installment Loans Can Help Raise Your Credit Score
The most important element of your FICO® Score☉ is your payment history. This factor alone accounts for 35% of your score, which is why consistently making all bill payments on time is one of the surest ways to improve and maintain excellent credit.
Because installment loans require monthly payments over an extended period of time, they give you the opportunity to make regular on-time payments that help you improve your score. On the flip side, missing even one payment or paying 30 days or more late will negatively impact your credit score. Choose payment options, like automatic debit, that will reduce the likelihood that you miss paying your bill.
A less weighty, but still important, factor in your score is credit mix. Since the FICO scoring algorithm is chiefly looking for a combination of both installment and revolving credit, adding an installment loan to your credit report when you've only used credit cards, or vice versa, can help give your scores a lift.
Credit mix accounts for 10% of your FICO® Score, so it's not as important as other factors. Also, since the potential downsides of taking on credit you can't manage are so consequential, it's not advisable to take on new credit solely to improve your credit mix.
Additional Ways to Boost Your Credit
The second most important determining factor in your credit score—just behind payment history—is credit utilization, or the amount of revolving credit you use relative to your credit limit. The lower the balances on revolving credit lines you carry, the less of a risk you appear to scoring algorithms and to lenders considering you for new credit.
It's ideal to pay off credit card balances every month, and to avoid using more than 30% of your credit limit at any time since doing so can start to have a bigger impact on your scores. If you limit the amount of credit card debt you take on, your score will reflect your ability to manage debt responsibly. (While installment loan balances are considered in FICO® Score calculations in the "amounts owed" category, credit utilization only includes revolving accounts. Installment balances will also impact your debt-to-income ratio, which lenders may consider when you apply for certain types of credit, like mortgages.)
Another way to improve credit is to give the credit bureaus access to your payment history for bills that otherwise may not be incorporated into your score. For example, if you use a bank account to pay for monthly streaming service, phone or utility bills, those payments traditionally wouldn't be considered in your credit score. Experian Boost™† changes that by allowing you to add these accounts to your Experian credit report and get credit for those on-time payments. Experian Boost is a free service that can instantly improve your FICO® Score based on your Experian credit file.
Using Installment Loans to Improve Credit
It's wise to only apply for the credit you need. Applications for new credit can have a brief negative effect on your credit score, and it's risky to take on new debt without the means to pay it off.
But if you were already in the market for an installment loan to buy a new car or home or attend college, improving credit can be a valuable secondary outcome of taking out a loan. Make all monthly payments on time so you can make the most of the credit-boosting opportunity an installment loan provides.