Key takeaways
- Personal loans can boost your credit score by adding to your credit mix and reporting a positive payment history.
- There are some risks associated with applying for a personal loan, including hard credit inquiries, additional debt and lender fees.
- Other ways to build credit include applying for a secured credit card, becoming co-signer or an authorized user on a credit account and reporting alternate payments.
Though they’re a form of debt, personal loans can also serve as a tool to build credit. This is because they can contribute to your payment history and credit mix, as well as lower your credit utilization ratio. Collectively, these three factors account 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 pieces — including risks — before deciding.
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 have a positive impact on your credit, as payment history accounts for 35 percent of your FICO score.
- Add to your credit mix. Having different types of credit accounts in good standing shows lenders that you’re able to manage different debts responsibly. By adding a personal loan to your report, you’re contributing to the diversification of your credit mix, which makes up 10 percent of your score.
- Reduce your credit utilization ratio. If used to consolidate revolving debt, such as credit cards and lines of credit, personal loans can reduce 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 paid consistently, any personal loan can be a positive addition to your credit report. That said, debt consolidation loans and credit-builder 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 debt. Let’s say you have three credit cards, each with an outstanding balance and relatively high interest rates. Consolidating this debt will allow you to 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 few ways. For one, if you pay off the balances of your credit cards, you’ll lower your credit utilization ratio. It could also improve your credit mix since credit-scoring models like to see a variety of revolving debt, like credit cards, and installment loans, like personal loans.
However, consolidating your debt only makes sense if you’re offered a lower interest rate on your new loan than your previous debts. Otherwise, you risk paying more in interest accrual over the life of the loan.
Financial institutions — like online lenders, banks and credit unions — can provide debt consolidation loans. To qualify for the best rates, you’ll need to have a solid credit score — typically 740 or higher — and have a stable source of income. Some lenders also allow co-borrowers or co-signers, which could 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 a better interest rate and want to consolidate the balances on their high-interest credit cards to streamline the repayment process.
Credit-builder loan
A credit-builder loan requires you to make fixed monthly payments over a set period. Unlike traditional personal loans, you won’t have access to the funds until the loan is paid in full with interest.
Once the funds are released to you, they are yours to use however you see fit. Some borrowers choose to increase their emergency fund. Others use the funds to pay down small debts or meet other short-term financial goals.
For some, credit-builder loans can feel counterintuitive, as you don’t gain access to the borrowed money until after you’ve paid it off. However, you’ll establish a history of timely payments, which will increase your score over time.
A credit-builder loan isn’t right for everyone, especially if you need the funds prior to paying down the balance. Plus, you may have to pay fees to open the loan and depending on your credit, the interest rate you’re offered could eat into the overall value of the loan.
Just like other kinds of personal loans, credit-builder loans are available through some banks, credit unions and online lenders. To apply for these, you typically don’t need to pass a credit check, just provide some personal information. This includes your full name, address, social security number, bank account information and rent or mortgage payment.
Money tip:Credit-builder loans are best for individuals with bad credit or no credit history who don't need immediate access to the funds.
Risks to bad credit personal loans
If you have a FICO score below 670, you may want to think it over twice before getting a personal loan to build credit. That’s because bad credit loans tend to come with much higher interest rates and fees compared to other loans. This, in turn, can make repayment more difficult on you, which may cause you to fall behind on payments and even default on the loan, further damaging your credit.
But even if you have good credit, it’s still important to take into account the risks to ensure you’re making the right choice for your situation.
Hard inquiry on your credit report
Any time you apply for a personal loan, you’ll get what’s known as a hard inquiry on your credit report. Hard inquiries will cause your score to temporarily drop 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 amount of time will decrease your score significantly and may be interpreted by lenders as a risk factor.
Close to sixty percent of people with credit card debt have been in debt for at least a year. Staying on top of your payments is important if you choose to use a personal loan to consolidate debt.
Gaining debt
Bankrate’s financial freedom survey found that out of all U.S. adults who do not feel financially secure, 26 percent say it’s due to high or revolving debt. Although applying for a personal loan can help you build credit, this also translates to more debt in your portfolio.
Carefully evaluate your situation before signing on the dotted line. Remember, you shouldn’t take out a loan if the debt is going to cause hardship, even when using a personal loan to help pay off debt and reduce your interest rate.
Associated fees
Depending on the lender, it’s likely that any loan you apply for will charge at least one fee. While they can seem like minor costs compared to the overall balance, multiple fees can add up and eat into the overall value of your loan.
Read the fine print in the terms and conditions to know what fees are associated with any loan before accepting a loan. If the lender you’re looking at charges multiple fees, it may be best to look elsewhere. Some companies boast that they charge very few fees, and a handful of lenders don’t charge any at all.
Alternative ways to build credit
If a personal loan isn’t the best way for you to build credit, these alternative methods — when used responsibly — can help boost your score over time:
- Secured credit card. These cards require you to put down a deposit in a separate account, which then becomes your credit limit. Secured cards can boost your credit through on-time payments. However, if you default on your payment, the lender or issuer can seize your collateral to recoup any losses.
- Joint accounts. Co-signing on a loan or becoming an authorized user on a credit card can help build your credit since both you and the account holder can benefit from a positive payment history. That said, co-signing has more serious implications than being an authorized user. That’s because you’re legally responsible for the loan.
- Report alternate payments. Some services, like Experian Boost, allow you to get credit for paying everyday bills, such as streaming services, monthly subscriptions and utilities, which typically aren’t reported to the credit bureaus. You can also ask your landlord to report rent payments to improve your score.
Bottom line
Personal loans can help you build credit if you use them to consolidate your debt or establish a timely payment history. If you choose to use a personal loan for credit building, remember to consider the risks involved. If you’d rather avoid taking on additional debt just for the sake of building credit, consider becoming an authorized user on someone’s credit card or reporting your everyday bills. Both options could improve your score without taking any major financial risks.
