Loans can be a useful tool to help cover the cost of significant expenses that you’re unable to pay for with cash — whether it’s a car, home, wedding, medical bill or some other big ticket item.
There are many different types of personal loans designed to help consumers cover these types of expenses. And often the money you borrow is paid back in equal monthly installments — which is known as an installment loan. In addition to helping you make major purchases, when managed responsibly installment loans also offer the benefit of building, or improving, your credit profile.
How an installment loan can build credit
An installment loan is a sum of money that you pay back over a specified period of time, typically between two and five years for a traditional personal loan. The loan balance is repaid with interest in regular monthly installments of a fixed amount.
When you open this type of account and consistently make the payments on time and for the agreed upon amount, it can be beneficial for your credit profile. There’s a few different ways an installment loan can help improve your score.
Establishes payment history
Perhaps the most valuable way installment loans can help boost your credit score is by allowing you to develop a history of making regular, on-time payments. Your score is calculated based on a number of different factors, and payment history has the most weight of them all.
“Thirty-five percent of your FICO score is your payment record. This is the single largest factor,” says Michael Sullivan, a personal financial consultant with the nonprofit financial counseling agency Take Charge America. “Because installment loans require regular payments, on-time performance will enhance your score.”
The key however, is making your monthly loan payments on time and not falling behind, to ensure that the loan is a positive addition to your profile.
Diversifies credit mix
Installment loans can also improve your credit score by diversifying or adding variety to the mix of accounts in your name. Having different types of accounts and managing them well can give your score a slight bump. Diversifying can include having both revolving accounts, such as credit cards, and installment accounts, such as student loans, auto loans or other types of personal loans.
“Credit mix makes up 10 percent of the credit score. While it’s not the most important element in credit scoring, it does play a part,” says Freddie Huynh, a vice president with Freedom Debt Relief. “For lenders, it provides an indication of how you manage different loans and lines of credit, which gives them more of an idea of how risky lending to you might be.”
While having a variety of account types can help your credit score to some degree, it is also entirely possible to build or maintain a solid credit score with just one type of account, such as credit cards.
Decreases overall credit utilization
You may also be able to improve your credit score when you use an installment loan to pay off credit card balances or consolidate debt. The increase in your score in this case would result from lowering your overall credit utilization ratio by paying off credit card balances with the loan.
Credit utilization ratio is the amount of your revolving credit you’re using relative to your total available revolving credit. This is another significant factor when your credit score is calculated, accounting for 30 percent of your overall score.
“If an installment loan is taken out for the purpose of paying off credit card or other revolving debt, it may actually improve your credit rating by removing a revolving account balance and adding an installment account, which does not have the same impact on your credit utilization,” Sullivan says.
How an installment loan can hurt credit
As with any type of debt, responsible repayment and management of the account is key. This includes installment loans. When not managed responsibly, an installment loan can have a negative effect on your credit score.
Missed loan payments
Just as a history of on-time payments can drive up your credit score, one or more missed or late payments can have a detrimental impact. Though identifying exactly how much this will hurt your score can be difficult, as everyone’s financial picture is slightly different.
“If you miss a payment, or are late with a payment, it will appear on your credit report and factor negatively into your credit scores,” Huynh says.
In addition, even the mere act of applying for the loan causes a slight dip in your credit score. This is because hard credit inquiries, which are typically required to establish a loan, draw down your credit score.
Too much debt
Taking on any new debt adds to your overall debt load and the new account can negatively impact your score.
This is because when you apply for a new account, such as a loan or a credit card, the lender does a hard inquiry on your profile, which can lower your score by about five points. Hard inquiries generally stay on your credit profile for two years, but they typically impact your score for a year or sometimes less.
For this reason, however, using an installment loan simply as a credit building exercise may not be the best justification.
Other ways to help your credit
While the best way to establish and maintain good credit is to use credit wisely and responsibly, there are other options beyond an installment loan that can help actively build or improve your score.
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Increase your available credit lines: Increasing your total available credit without actually using that credit will decrease your credit utilization ratio.
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Secured credit cards: Secured credit cards are typically backed by a cash deposit you make that’s equal to the credit card’s spending limit. These cards allow for building credit and practicing good credit habits such as making on time payments and responsibly repaying debt. And because secured credit cards can only be used up the amount of cash available, there’s less opportunity to overspend and get in over your head.
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Secured loans: Some lenders will permit a borrower with a limited credit history or lower credit score to obtain a secured loan. Secured loans, such as auto loans, are installment loans backed by collateral. If the borrower defaults, the lender can repossess the collateral, which makes these loans somewhat less risky.
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Pay all bills on time: By consistently paying all of your bills by their due date and doing this over years, you will establish a solid track record and history of managing and repaying debt responsibly. Payment history is the single biggest factor contributing to your credit score.
Only take out an installment loan if necessary
Installment loans can be a valuable financial tool to help cover significant expenses and when used and repaid responsibly as agreed, can help build or improve your credit score. The most valuable way installment loans impact your score is by allowing you to establish a track-record of making consistent, on-time payments.
Taking out a loan simply as a credit building tool, however, may not be the wisest decision. There are other less risky ways to improve your credit score without borrowing large sums of money that you’ll be responsible for paying back. One of the easiest tactics is to use a credit card for routine daily purchases, paying the balance in full each month and making the payments on time.
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