Loan Advice Best Practices

How to Use an Installment Loan to Build Your Credit

by Jim Hughes   Oct 09, 2019

A low credit score doesn’t have to stay that way. Using these tips may help boost your score, opening the door to better financing options in the future. If all you qualify for is an installment loan, then one option is to get it, pay it off, and build your credit for next time.

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A credit score is a number that reflects an individual's history of debts and repayments. Low credit scores can be caused by missed payments, high amounts of existing debt, or a lack of borrowing history. Individuals may consider taking out an installment loan to improve their credit score and increase their chance of receiving other lending opportunities.

What is an Installment Loan?

An installment loan is a loan that is borrowed in a single lump sum and repaid in several pre-planned installments. Auto loans, mortgages, and personal loans are all different types of installment loans.

It is sometimes possible to build your credit using an installment loan.

There are two kinds of installment loans that may be offered to individuals who are trying to build their credit:

  • An unsecured loan is a traditional installment loan. Money is offered based on things like the borrower's needs and credit score. The borrower is then expected to make timely payments until the loan has been repaid in full.
  • A secured loan requires a deposit or collateral; this is usually for at least the same value as what is to be borrowed. Secured loans are offered by banks and credit companies. They may help improve individuals' credit scores.

The amount, interest rate, and repayment terms of an installment loan may depend on the borrower's current income and credit. Individuals who choose poor credit installment loans may need to pay a higher amount of interest or choose a secured loan. Lenders usually ask that borrowers have enough income to repay the loan on time.

How Do Installment Loans Help Build Credit?

Those who pay back loans on time may see their score increase.

Making timely payments almost always improves an individual's credit score. Someone with a history of missed payments can repay a secured installment loan and show financial institutions that they have changed their habits. Moderate credit scores may be improved with the steady repayment of an installment loan.

Installment loans are frequently used to improve the borrower's credit mix. Roughly 10 percent of a credit score is determined by the different types of credit that the individual has available. If a borrower has several open credit cards but no long-term loans, their credit score may be boosted by adding an installment loan to the mix.

Credit scores are also determined by the funds that are available on each open line of credit. A score may be positively impacted if less than 30 percent of the funds available on each credit card has been used.

Many people use installment loans to pay down credit cards that are near their maximum credit. If the installment loan has a better interest rate and repayment terms than the credit cards, this can be a good way to improve someone's financial situation. This method won’t work if the borrower immediately fills the credit cards up again.

When Installment Loans May Help

An installment loan might be a good way to build credit if:

  • The borrower generates enough revenue to make steady payments.
  • The borrower has time to wait for their credit score to improve.
  • The borrower does not take out additional loans.
  • The borrower does not have a credit history and would like to build one.

An individual should only take out an installment loan if they are certain of their ability to repay it. Even if the credit agency is willing to offer the loan, the individual may not be ready to use their income for the intended purpose. Borrowers should perform an honest financial assessment and consider the ways that they typically use their disposable income. If a significant amount of income goes into their savings account, it might be a good time to consider a credit-building loan.

Installment loans take time to repay; consequently, it takes time to improve the borrower's credit score. They are never a quick-fix solution for bad credit. An individual should consider using an installment loan to improve their credit score when they are in a financially good situation and might be planning to buy a house or start a business within the next five years. The loan will help establish a good credit history and improve the interest rate of future loans.

Credit-building loans are particularly useful for individuals without an extensive credit history. Without a history of either missed or on-time payments, financial institutions cannot assign a reliable credit score. Personal loans can be used to build a solid framework on which to apply for installment loans, auto loans, mortgages, and business loans later in life.

Building Credit with On-Time Payments

For an installment loan to have any chance at improving an individual's credit score, the payments must be made on time. Late or missed payments will actually harm the credit score; because of this, personal loans should only be accepted when the individual is confident in their current financial situation.

When using it to build credit, borrowers should take care not to pay off the loan too early. The basis of good credit is a history of on-time payments in which interest is allowed to accrue. Many personal loans will actually charge a fee for early repayment. If the borrower has enough money to pay the loan off at once, they should place that money in a savings account and set up automatic payments.

The easiest way to ensure that an installment loan will be repaid is to take out as little money as possible. The size of a personal loan may not particularly impact the individual's credit score, and smaller loans also mean smaller monthly payments. Small installment loans between $1,000 and $5,000 are an excellent place to start building credit.

Borrowers should also consider the repayment term of the loan. To build credit, look for a term between 12 and 24 months. Longer repayments may not have the same positive impact on the borrower's credit score, and an individual's financial situation can change significantly over two or three years.

The Risks and Drawbacks of Installment Loans

The greatest risk of taking out a personal loan is that the borrower may be unable to pay it back. Missed payments and defaulted loans will quickly lower an individual's credit score.

Next, borrowers should consider the interest rate of the loan. Individuals with poor credit may only be offered loans with steep interest rates. The small increase in credit may not be worth the cost of repaying the interest alongside the loan.

In general, anyone who wants to rebuild their credit should consult with a financial advisor. Building a healthy credit score takes time and planning; advisors will consider factors like the individual's existing credit history, current financial needs, and future career prospects.

Jim Hughes, author at OpenLoans
Director of Content
Look to Jim for advice on budgeting, savings, insurance, stocks, retirement funds, and other topics in personal finance.
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