Loans can be a useful tool to help cover the cost of significant expenses that you’re unable to pay for with cash. A car, home, wedding, medical bill or some other big ticket item can all be covered with a personal loan.

There are many types of personal loans designed to help consumers. Often, the money you borrow is paid back in equal monthly installments — which is known as a personal installment loan. Installment loans also offer the benefit of building, or improving, your credit profile when managed responsibly.

Key takeaways

  • Installment loans are repaid in fixed monthly payments.
  • Installment loans can help improve your credit score over time with regular payments.
  • Installment loans give you access to funds for a variety of large expenses.

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 to five years for a traditional personal loan. The loan balance is repaid with interest and any relevant fees in regular, fixed monthly installments.

When you open this type of account and consistently make payments, it can be beneficial for your credit profile. There are a few ways an installment loan can help improve your score, and if you stick to healthy habits, your score could increase in a matter of months.

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 credit score is calculated based on a number of factors, but payment history has the most weight.

“Thirty-five percent of your FICO score is your payment record. This is the single largest factor,” says Mike Sullivan, Director of Education at 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 payments on time. This will ensure that the loan is a positive addition to your profile and not a harmful one.

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, like credit cards, and installment accounts, like installment 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, the former vice president of data optimization at 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 your loan is key. When not managed responsibly, an installment loan can have a lasting, 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 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. While you usually get a short period where you can apply for several of the same type of loan at once — like an auto loan — without affecting your credit, you should avoid applying for several types of credit near each other.

Too much debt

Taking on any new debt adds to your overall debt load and the new account can negatively impact your score. If you have too much debt it will affect the “amounts owed” portion of your credit score, which makes up 30 percent of a FICO credit score.

For instance, if you already have a mortgage, student loans, an auto loan and credit card debt, adding an installment loan may increase your debt-to-income (DTI) ratio. Lenders will be less likely to consider you if your DTI is too high because it will put unnecessary strain on your budget.

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.

  • Increase your available credit lines: Increasing your total available credit without actually using that credit will decrease your credit utilization ratio.
  • Secured credit cards: Secured credit cards allow you to put up a set amount — like $500 — and borrow against it. While the APR can be high, you may be able to avoid annual fees and build your credit as you borrow and repay. 
  • Secured loans: Secured loans, like auto loans, are installment loans backed by collateral. If the borrower defaults, the lender can repossess the collateral, which makes these loans less risky for lenders.
  • 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 repaid responsibly, 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 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. 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.