Key learning points
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Personal loans can improve your credit score by replenishing your credit mix and reporting a positive payment history.
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There are some risks associated with applying for a personal loan, including hard credit applications, additional debt, and lender fees.
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Other ways to build credit include applying for a secured credit card, becoming a cosigner or authorized user of a credit account, and reporting alternative payments.
Although they are a form of debt, personal loans can also serve as a credit-building tool. This is because they can add to your payment history and credit mix, and lower your credit utilization ratio. Collectively, these three factors are responsible for 75 percent of your credit score.
But just because they’re a good credit-building tool for some doesn’t mean they’re the right strategy for you. Consider all the moving parts (including the risks) before making a decision.
Why using a personal loan can help build credit
There are three main ways a personal loan can benefit your credit:
- Build a positive repayment history. When you take out a loan, lenders report your payment activity to the three major credit bureaus: Experian, TransUnion and Equifax. On-time payments positively impact your credit score, as payment history makes up 35 percent of your FICO score.
- Add to your credit mix. Having several types of credit accounts in good standing shows lenders that you are able to manage various debts responsibly. By adding a personal loan to your report, you help diversify your credit mix, which makes up 10 percent of your score.
- Lower your credit utilization ratio. If personal loans are used to consolidate revolving debt, such as credit cards and lines of credit, they can lower your credit utilization ratio. This factor accounts for 30 percent of your FICO score and measures how much credit you’ve used relative to your available limit.
Which personal loans can help build credit?
If you make consistent payments, any personal loan can be a positive addition to your credit report. That said, debt consolidation loans and credit-building loans are a better option if your main goal is to increase your credit score.
Debt consolidation loan
As the name implies, these loans are personal loans used to consolidate debts. Suppose you have three credit cards, each with an outstanding balance and relatively high interest rates. By consolidating these debts, you can borrow the money you need to pay off all three cards under a new loan with one fixed monthly payment.
This can help your credit in a number of ways. First, when you pay off the balance on your credit cards, you lower your credit utilization ratio. It could also improve your credit mix, as credit scoring models like to see a variety of revolving debt, such as credit cards, and installment loans, such as personal loans.
However, consolidating your debts only makes sense if you are offered a lower interest rate on your new loan than your previous debts. Otherwise, you risk paying more interest over the life of the loan.
Financial institutions – such as online lenders, banks and credit unions – can provide debt consolidation loans. To qualify for the best rates, you must have a solid credit score (usually 740 or higher) and a stable source of income. Some lenders also allow co-borrowers or co-signers, which can help you qualify for a better loan if your credit is less than ideal.
Money tip: Debt consolidation loans are ideal for individuals who qualify for better interest rates and want to consolidate balances on their high-interest credit cards to streamline the repayment process.
Credit building loan
A credit-building loan requires you to make fixed monthly payments over a set period of time. Unlike traditional personal loans, you cannot access the money until the loan is paid off in full, including interest.
Once the money is released to you, you can use it as you see fit. Some borrowers choose to increase their emergency fund. Others use the money to pay off small debts or achieve other short-term financial goals.
For some, credit-building loans can feel counterintuitive because you don’t get access to the borrowed money until you’ve paid it off. However, you will build a history of on-time payments, which will increase your score over time.
A credit-building loan isn’t for everyone, especially if you need the money before paying off the balance. Additionally, you may have to pay fees to open the loan and depending on your credit, the interest rate you are offered could negatively impact the overall value of the loan.
Like other types of personal loans, credit-building loans are available from some banks, credit unions and online lenders. You usually don’t have to go through a credit check to apply for this. You only need to provide some personal information. This includes your full name, address, social security number, bank account details and rent or mortgage payment.
Money tip: Credit building loans are best for individuals with poor credit or no credit history who do not need immediate access to the funds.
Personal Loan Risks With Bad Credit
If you have a FICO score below 670, you may want to think twice before taking out a personal loan to build credit. That’s because bad credit loans often come with much higher interest rates and fees compared to other loans. This, in turn, can make repayment more difficult for you, which can lead to you falling behind on payments and even defaulting on the loan, further damaging your credit.
But even if you have good credit, it’s still important to consider the risks so you make the right choice for your situation.
Difficult inquiry into your credit report
Every time you apply for a personal loan, you’ll be asked what’s called a hard inquiry about your credit report. Hard inquiries will temporarily drop your score a few points, but it’s generally easy to rebuild your score with a good repayment history.
One inquiry at a time is manageable and even expected by lenders, but multiple inquiries in a short period of time will significantly lower your score and may be interpreted as a risk factor by lenders.
Nearly sixty percent of people with credit card debt have been in debt for at least a year. It’s important to stay on top of your payments if you choose to use a personal loan to consolidate debt.
Getting into debt
Bankrate’s financial freedom survey shows that of all American adults who do not feel financially secure, 26 percent say it is due to high or ongoing debt. While applying for a personal loan can help you build credit, it also translates into more debt in your portfolio.
Evaluate your situation carefully before signing on the dotted line. Keep in mind that you shouldn’t take out a loan if the debt is going to cause problems, even if you use a personal loan to pay off debt and lower your interest rate.
Associated costs
Depending on the lender, it’s likely that you’ll be charged at least one fee for each loan you apply for. While this may seem like a small charge compared to the total balance, several charges can add up and eat up the total value of your loan.
Read the fine print in the terms and conditions to find out what costs are associated with a loan before accepting a loan. If the lender you’re looking at charges multiple fees, it’s best to look elsewhere. Some companies brag that they charge very little fees, and a handful of lenders don’t charge any fees at all.
Alternative ways to build credit
If a personal loan isn’t the best way to build credit for you, these alternative methods – when used responsibly – can help improve your score over time:
- Secured credit card. These cards require you to make a deposit into a separate account, which then becomes your credit limit. Secured cards can boost your credit with on-time payments. However, if you default on your payment, the lender or issuer may seize your collateral to make up for any losses.
- Joint accounts. Co-signing for a loan or becoming an authorized user of a credit card can help build your credit because both you and the account holder can benefit from a positive payment history. That said, co-signing has more serious consequences than being an authorized user. You are legally responsible for the loan.
- Report alternative payments. Some services, like Experian Boost, allow you to get credit to pay everyday bills, such as streaming services, monthly subscriptions, and utilities, that are typically not reported to the credit bureaus. You can also ask your landlord to pass on rent payments to improve your score.
In short
Personal loans can help you build credit if you use them to consolidate your debts or build an on-time payment history. If you choose to use a personal loan to build credit, consider the risks involved. If you’d rather avoid taking on additional debt just to build credit, consider becoming an authorized user of someone’s credit card or reporting your daily bills. Both options can improve your score without taking major financial risks.
