A Guide To Using Personal Loans To Build Credit

6 Min Read

Updated July 13, 2023

FACT-CHECKED

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What do job applications, interest rates and insurance premiums have in common? Your credit score influences your favorability and success with each. Building a strong credit score does more than indicate to banks that you can handle a loan. It helps with numerous facets of life. Therefore, making a concerted effort to boost your credit is crucial. Fortunately, you can use personal loans to build credit by making your payments on time. Doing so means taking out a loan you can afford and paying it off on schedule. Here’s how to use a personal loan to improve your credit.

How Personal Loans Can Build Credit

When used wisely, a personal loan can help your credit score in the following ways.

Builds a good payment history: One aspect of your credit report is your history as a borrower. Banks and financial institutions consider your credit history when deciding to provide a loan. In addition, a consistent payment history boosts your credit score.
Reduces credit utilization ratio: Generally, taking on more debt hurts your credit utilization ratio, which indicates how much debt you’re carrying vs. the revolving credit available. For example, if you have a credit card with a $10,000 line of credit and you have $5,000 of debt on the card, you have a credit utilization ratio of 50%.
Your credit utilization ratio is another factor impacting your overall credit profile. Fortunately, personal loans don’t count toward your revolving credit. Therefore, a personal loan won’t reduce your credit score in this way.
Diversifies credit mix: A limited credit history doesn’t boost your score as much as one with various types of credit. For example, a credit history with only a credit card is weaker than one with two credit cards, a mortgage and an auto loan (provided you aren’t behind on any of the payments). That’s because it shows you can handle different types of debt.

Risks Of Using A Personal Loan For Your Credit

While a personal loan provides multiple advantages for your credit, it also presents several risks.

Missing Or Making Late Payments

As with any debt, missing payments and paying late will damage your credit. Therefore, it’s best to assess your financial situation and ensure you can make the required payments on time before taking out a personal loan.

Hard Credit Pull

Applying for a personal loan means the lender will perform a hard credit pull when determining your worthiness as a borrower. A hard pull means the lender examines your credit reports, and your credit score drops by a few points. Fortunately, the slight decrease will bounce back within a couple of months if you maintain healthy credit habits.

If you’re looking for a personal loan, it’s best to apply with several lenders within a month instead of spacing out applications because the additional pulls won’t count against you.

Accumulating Debt

Lastly, a personal loan means another debt to carry. You’ll have a higher monthly debt payment than before and pay interest on the principal, costing you more money over time. It’s crucial to manage your debt so it doesn’t spiral out of control. If you’re struggling, you can read more about getting out of debt.

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Tips For Using A Personal Loan To Build Credit

Now that the upsides and downsides of a personal loan are clear, here’s how to use one for building your credit.

Shop For Lenders

The terms and rates for personal loans vary among lenders, so it’s best to explore multiple offers. During this phase, your job is to hunt for the best interest rate and get assurance from the lender that they will report the loan to the three major credit bureaus. This way, repaying the loan will strengthen your credit score.

Don’t Borrow More Than You Need

You might qualify for a bigger loan than you first set out to obtain. While receiving several thousand dollars more can be tempting, it’s best to stay with the amount you initially intended. Otherwise, your monthly payment will be larger, and you’ll pay more interest. Keeping your eyes on the purpose of the loan, such as a home improvement project or car repair, will keep your monthly payment low and increase your ability to pay the loan off on time.

Consider Your Monthly Payment

Remember, your monthly loan payment contributes to your preexisting monthly expenses. For example, a car loan, rent/mortgage and student loans are additional monthly financial responsibilities. Once you receive an estimate from your lender about the monthly payment, it’s wise to assess your financial ability to make the payment considering your other monthly expenses.

Review The Loan Terms

Personal loans come with details and fees that are as significant as the loan amount. For example, your lender might charge an origination fee for providing the loan or a prepayment penalty if you pay the loan off too early. In addition, a variable interest rate means your monthly payment will fluctuate due to economic trends. Therefore, knowing the loan terms front to back before signing the dotted line is critical to your success.

Alternatives To Using A Personal Loan To Build Credit

While a personal loan can help build credit, other debt instruments do the same job while providing other advantages. Consider these options during your search:

Current credit accounts: You might already have a sufficient debt load from your other loans. For instance, an auto loan, student loan and mortgage can boost your credit score if you pay all of them on time. Together, these three loans could prevent the need for a personal loan.
Credit card: Your credit card is an excellent credit-building tool. Using it for regular monthly expenses, such as groceries or gas, and paying the balance when it’s due will strengthen your credit over time. If you don’t have a credit card and are struggling to qualify for one, you may have an easier time getting a secured credit card.
Credit-builder loan: A credit-builder loan provides a sum (usually $300 to $1,000) that becomes available at the end of the term. A low credit score usually doesn’t prevent borrowers from accessing these loans because banks offer them to help customers build credit. Making timely payments throughout the loan will help your credit score and provide a modest loan amount when you finish paying.
Reporting alternative payments: Debt payments aren’t the only way to boost your credit score. Instead, you can request that specific service providers report your payments to the credit bureaus. For example, your rent, utility and cell phone payments may be eligible for alternative payment reporting.

The Bottom Line: Personal Loans Can Help Build Your Credit

Personal loans can be a viable way to build your credit score when used responsibly. By making on-time payments on an affordable loan amount, you can boost your credit and accomplish a financial goal. By shopping around, you can find a personal loan that works for your budget.