An installment loan is where you borrow a specific sum of money and pay it back in a series of regular payments, or installments. Most installment loans require making payments on a monthly schedule. Auto loans, student loans, mortgages and personal loans are all types of installment loans.
Taking out an installment loan can enhance your credit history and promote improvements in your credit scores. The credit score increases won't be instant, however, and except for one scenario, they generally won't be huge.
How Installment Loans Benefit Credit Reports and Scores
The credit reports compiled at the national credit bureaus (Experian, Equifax, and TransUnion) document your history of borrowing money and repaying debts. Each loan reflected on your credit report broadens and extends your credit history.
As long as you make payments on a timely basis, in the full amount required under the loan terms, an installment loan will reflect positively on your ability to manage debt responsibly, and it will tend to improve your credit score.
An additional benefit of an installment loan can be enhancing your credit mix—the number and variety of loans (or accounts) that appear on your credit report. Credit scoring models—the statistical algorithms that distill the contents of your credit reports into three-digit scores—generally favor credit histories with a variety of loan types.
More specifically, a blend of installment debt and revolving debt can benefit your credit scores. Revolving accounts are those such as credit cards and certain home-equity loans, which allow you to borrow against specific credit limits, and make payments of varying size each month.
If revolving accounts dominate your credit portfolio, adding an installment loan will improve your credit mix, which will tend to improve your credit scores.
Installment Loans Can Work Double-Time For You
The credit benefits of a new installment loan are generally big-picture in nature: They promote steady score improvements over time but generally don't bring major near-term improvements.
There is one situation, however, in which an installment loan can boost your credit scores significantly within a relatively short amount of time. If you have credit cards with a high level of credit utilization, an installment loan that helps you pay off your credit card balances could boost your credit scores significantly within a matter of months.
- Credit Utilization Rate: the percentage of your borrowing limit represented by your outstanding credit-card balances— accounts for about 30% of your FICO® credit score, and utilization rates greater than about 30% negatively impact your credit scores. Very high utilization rates, like those that occur when you get close to "maxing out" credit cards, can significantly lower your credit scores.
- Debt Consolidation Loan: a personal installment loan you use to pay off high credit card balances—can be a real win-win. Reducing your utilization rate can lead to significant score increases relatively soon, as long as you keep up with the installment-loan payments and—this is critical—avoid letting your credit card utilization rate creep up above 30% again. In addition to the short-term score boost, you'll get the longer-term benefits of adding an account in good standing to your credit report and increasing your credit mix.
Short-Term Credit-Score Reductions
It's important to remember that any time you apply for a loan, whether it's an installment loan or a revolving loan, the lender makes a hard inquiry against your credit report, and that can cause a small drop in your credit scores.
When a loan application is approved, you may also see small incremental score reductions. These normal drops reflect the statistical reality that borrowers who seek to take on new debt are at higher risk for defaulting on their other loans. As long as you continue to pay all your bills on time, your scores will typically recover within a few months.
A temporary reduction in your credit scores shouldn't stop you from seeking an installment loan, but you might want to take these short-term score impacts into account if you'll be seeking more than one loan within a year.
If you plan to finance a car and apply for a mortgage, for example, it might be wise to space the loan-application processes out by six months or more, so your credit scores have time to rebound from the first loan before you apply for the second.
The main reason to seek an installment loan (or any personal debt) is to meet your needs—for an education, a vehicle or home, or to better manage your debts. As long as you handle it responsibly and make your payments on time, an installment loan can have a positive impact on your credit profile.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.