Can Taking Out a Personal Loan Improve Your Credit?
If you’re young, just out of school and building your career, your score is likely in the poor to fair range. According to FICO, while the average credit score is 704, credit scores for millennials and younger generations are under 700. Your credit score affects everything from what rates you get on a loan to whether you’ll get approved for an apartment, so establishing good credit is important.
The more positive activity reported to the big three credit bureaus (Equifax, Experian and TransUnion), the higher your score can go. And using a variety of credit products, such as a personal loan and a credit card, will help ramp up your credit score faster.
How can a personal loan improve your credit?
Taking out debt to build your credit profile may sound counterintuitive, but it really works, if you handle it wisely. Credit scores are determined using five criteria, with each carrying a different weight: payment history (35%), credit utilization (30%), length of credit history (15%), and credit mix and new credit (10% each).
Here’s how a personal loan can boost your credit score:
- Reduces your credit utilization ratio: If you take out a personal loan to consolidate your credit card debt, you can lower your credit card(s) utilization. You’ll use the personal loan to pay off your credit card balances, showing greater unused credit. Personal loans aren’t factored into credit utilization since they are installment loans with a fixed repayment plan.
- Diversifies your credit mix: Having a mix of different types of credit, such as credit cards and loans, and handling them responsibly, shows lenders that you’re able to juggle a variety of credit products.
- Positive payment history gets reported to the credit bureaus: When you make consistent and timely payments on a personal loan, that activity is reported to the three major credit bureaus.
Know that once you decide on a lender and apply for a personal loan, the lender will perform a hard inquiry of your credit to evaluate your creditworthiness. This is known as a hard inquiry and will actually knock down your credit score a few points temporarily. However, the long-term positive impact of successfully repaying a personal loan will most certainly outweigh any short-term ding to your score.
Do’s and don’ts when considering a personal loan to rebuild credit
If you’re not careful, taking out a personal loan can actually worsen your debt problem and cause your score to drop. To keep that from happening, make sure you follow these five tips.
1. Do use a personal loan for the right reasons
When compared with higher-interest forms of debt, such as credit cards, personal loans can make a lot of sense. But that doesn’t mean you should take out a personal loan to finance extravagant purchases or rack up new charges on the credit cards you just paid off with the loan. Instead, use it as a means to an end.
For example, if you have credit card debt or other high-interest debts, taking out a personal loan to consolidate your debt is a good idea because you’ll save money. But using a personal loan to pay for a vacation will only add to your debt burden.
2. Don’t borrow more than you need
When you apply for a personal loan, you could be approved for as much as $50,000. While it may be tempting to accept that amount so you have access to plenty of cash, doing so is a recipe for disaster.
Borrow the absolute minimum you need to meet your goals. Having a smaller loan will make the payments more manageable and will increase your chances of being able to pay it off on time.
3. Do continue to use and pay off your credit cards in full each month
If you use a personal loan to pay off high-interest card debt, don’t just put those cards in a drawer and forget about them. To continue to build up your credit score, you need activity reported from both your cards and your loan. However, just put a small charge, like a Netflix subscription, on the cards each month and pay the balance off at the end of the month. Establishing good credit habits will help you save money and become debt-free.
4. Don’t take out a loan without shopping around for the best deal
Don’t just apply for a loan with the first lender you see. Interest rates can vary widely from lender to lender. It’s a good idea to shop around and compare offers from multiple personal loan lenders so that you get the best rates and repayment terms.
5. Do figure out how much you can afford to pay monthly
Before applying for a personal loan, make sure you can afford the monthly payments. Factor in the interest rate, loan amount and length of the loan using a personal loan calculator.
- Create a budget: Make sure you understand what money you have coming in and going out each month.
- Calculate your monthly payment: MagnifyMoney, which is owned by LendingTree, has a personal loan calculator to help you figure out your monthly costs. For example, a $10,000 loan at a 6% APR for three years will cost you $304 a month. You’ll pay $952 in interest — or $10,952 total. But if you need a lower monthly payment, you could consider the same $10,000 loan at the same APR over a five-year term. This would shrink your monthly payment by more than $100 to $193 a month, but you’d pay $11,600 over the life of the loan, which is $648 more than you’d pay if you went with the three-year term.
Steps to take when applying for a personal loan
If you decide that taking out a personal loan to build your credit is right for you, you can move on to finding a personal loan lender and submitting your application. You can complete the process in four steps.
1. Get your credit score
Lenders look at a number of factors when evaluating your personal loan application to see if you’re a good candidate, including your income and credit score. Generally, lenders look for applicants with credit scores that are good or excellent. If you know your credit score is less than stellar, you can still qualify for a personal loan — you just may get a higher interest rate.
You can sign up for My LendingTree to get your free credit score each month.
If you have fair or poor credit, another option is to apply with a co-signer. A co-signer acts as a guarantor on the loan, so if you fall behind on your payments, they make them for you. A co-signer lessens the risk to the lender, making it more likely you’ll get approved for a loan and qualify for a lower interest rate.
2. Compare offers from lenders
To see offers from lenders, simply fill out LendingTree’s online form and compare offers from up to five different personal loan lenders depending on your creditworthiness.
While filling out the online form, you can detail how much you want to borrow, your desired payment term and how much you can afford to pay each month. When you receive offers from lenders, make sure you compare the loan terms to find your best loan.
3. Submit your application
Once you find a loan and repayment terms that work for you, you can proceed to the application stage. This process could take just a few minutes to complete, but you’ll be asked to submit your name, address, income information, employment status and how much you pay each month for rent or your mortgage.
4. Receive your money
Once you submit your application and the lender approves you, the lender will disburse your money. If you’re working with an online lender, it can take as little as 24 hours to get the money in your account. Others take a few days before they’ll issue you the money.
Once the loan is disbursed, you’re responsible for making regular monthly payments. Make sure you know the payment due dates to avoid falling behind.
Alternative ways to build credit
While a personal loan can be a great tool for building your credit, it’s not your only option. There are several other ways to establish good credit.
- Apply for a secured credit card: Unlike traditional credit cards, secured credit cards require a security deposit that serves as your credit line. Perfect for those with no credit or bad credit, secured credit cards act like a credit card with training wheels, helping you establish good habits.
- Take out a credit-builder loan: With a credit-builder loan, you basically borrow from yourself. You apply for a loan and make payments toward it each month, but don’t actually get access to the funds until after the loan term is completed, when the full amount is issued to you. It’s safer than a traditional loan, and your on-time payments are reported to the credit bureaus.
- Get a peer-to-peer loan: If you have poor credit, qualifying for a loan can be difficult. One option to consider is applying for a peer-to-peer loan, where lending standards may be lower.
- Apply for a car loan: If you plan on buying a car, the loan you take out to finance your purchase can help boost your credit, too. Like a personal loan, an auto loan diversifies your credit mix, and on-time payments are reported to the credit bureaus.
The bottom line
If you’re trying to improve your credit score, taking out a personal loan can make a lot of sense, particularly if you have high-interest debt. Personal loans can help you consolidate your debt, save money and get out of debt faster, all while boosting your credit score.
But before submitting your loan application, make sure you have a repayment strategy in place to avoid racking up more debt. By establishing a plan of attack, you can tackle your debt and increase your credit.
If you have bad credit, don’t give up hope. There are personal loans for those with bad credit, which can help you improve your credit history.