If you’ve financed a car or home, you’re well aware of installment loans and how they work. But did you know that there are installment loan products that are solely offered to help build credit?
They’re referred to as credit builder loans and are slightly different from traditional personal loans. However, they’re a tool worth considering for credit newbies or those who’ve had credit issues in the past.
In this guide, you’ll learn more about how both installment and credit builder loans work. You’ll also discover the benefits of using a credit builder loan and how they can help you build credit and save money.
What are Installment Loans?
An installment loan is a debt product that requires payments for a set period. You’ll generally pay a set amount each month for principal and interest until the loan is paid off. To illustrate, if you get approved for a 5-year, $20,000 installment loan with a 9 percent interest rate, your monthly payment will be $415.17. Plus, you will pay $4,910.03 worth of interest over the life of the loan.
Lenders offer two types of installment loans – secured and unsecured. Secured loans require collateral, like a car, home, or boat, to get approved. This gives the lender reassurance that they’ll recoup their losses if you default on your payments, as they can seize your asset and resell it. You can also get a lower interest rate if you use collateral, but not every lender offers this option for their financing.
Unsecured loans pose more risk to the lender as they are not secured by collateral. As a result, some lenders assess a higher interest rate to account for the elevated risk of loss.
Regardless of which type of loan you apply for, the lender will take a look at your credit report, income, and outstanding debts to determine if you can make monthly loan payments. In addition, most lenders have minimum credit score requirements.
Lenders without these requirements aren’t always giving you the best deal. Car title loans and payday loans do not have credit score requirements, but they also have triple-digit interest rates. This is one of the many reasons why it is important to build your credit score. A good credit score lets you access better financing opportunities.
Types of Installment Loans
Traditional banks, credit unions, and online lenders provide installment loans for consumers. You may already have an installment loan or be considering a loan that can improve your credit history.
Personal Loans
You can use a personal loan in any way you desire. These loans are more accessible, but a low credit score will result in a higher APR.
Auto Loans
Not paying in cash can provide the financing you need to build your credit score. Monthly loan payments will be reported to the major credit bureaus. If you do not have the best credit score, it may become more difficult to get an auto loan. However, if you make a large down payment and opt for a longer loan, you can increase your chances of getting approved.
Student Loans
Student loans are installment loans that can help your credit score if you make on-time payments. However, these same loans can take a toll on your credit score if you don’t make on-time payments.
Mortgage Loans
You will need a great credit score to get the best terms, and this isn’t where you would start. Most aspiring homeowners have already taken out a line of credit (i.e., credit card) or another financing product to build their credit scores. If you do have a mortgage, those on-time monthly payments will add up. You will strengthen your credit score and build equity in your home over time.
Do Installment Loans Build Credit?
Installment loans can help you build good credit. These loans provide applicants with two key benefits that help build credit:
- Payment history: This component of your credit score accounts for 35 percent of your FICO score. Making timely debt payments each month is pertinent if you want to attain good or excellent credit. You will also avoid late fees and other challenges if you pay each monthly payment on time. Installment loans can help you establish a stellar payment history if you make the payments on time over the loan term. But if you fall behind on payments and your account reaches 30 days past due, your credit score could drop by several points. You should only take out loans you can afford, and you can opt for a loan with more years on it to minimize your monthly payments.
- Credit mix: Lenders like to see a healthy combination of installment and revolving (i.e., credit cards) accounts on your credit profile. Although it only accounts for 15 percent of your credit score, an installment loan could help optimize your credit mix if you currently only have credit cards.
Other Factors that Impact Your Credit Score
Installment loans have an immediate impact on your payment history (35% of your score) and credit mix (10% of your score). However, there are three other factors that impact your credit score. Knowing the remaining components of your FICO score can help you make more prudent decisions about how you manage your money.
- Credit Utilization Ratio: This metric makes up 30% of your score. This ratio measures your borrowed funds against your credit limit. If you borrow $500 on a credit card with a $2,000 limit, you have a 25% credit utilization ratio. A ratio below 30% will improve your score, but it’s best to get this number below 10%. The only two ways to improve your credit utilization ratio are to pay down debt and get a higher credit limit. If you pay your debt on time every month, the credit limit does not matter. If you have difficulty obtaining a credit card with your current score, you can apply for a secured credit card instead.
- Credit History: As your credit age, your score will go up. Creditors give applicants an edge if they have more experience with juggling financial obligations and paying off debt. This category explains why most people recommend keeping your credit card open even if you do not use it anymore. Closing accounts reduces your credit history, which can hurt your score. The length of your credit history makes up 15% of your score.
- New Credit: Applying for new credit can hurt your score if it results in a hard credit inquiry. You will only lose a few points if you apply for new credit, but this can become more significant if the loan applications pile up in a hurry. New credit makes up 10% of your FICO credit score.
Should You Get an Installment Loan to Build Credit?
When you apply for credit, a hard inquiry is generated, and your credit score could drop by a few points. This ding is only temporary, though, which could make applying for an installment loan worthwhile. It can become problematic if you apply for too many loans in a short amount of time, but if you only apply for a few, it won’t be as much of an issue. Most lenders let you prequalify for a loan without a hard credit check, and some even provide preapproval without triggering a hard credit inquiry.
You may feel overwhelmed looking at high interest rates on personal loans and other installment loans, but you can take out a smaller loan to repair your credit score. A credit builder loan can give you a fresh start and put you back in control of your personal finances.
