Personal Loans

Using Personal Loans to Rebuild Credit

personal loans for rebuilding credit

So you’d like to improve your credit score but aren’t sure where to start. Fortunately, you have options, one of which is using a personal loan to rebuild your credit.

“Wait a minute,” you say, “how can going into debt be good for credit?” It’s an understandable question, but think of it this way: Strengthening your credit is like going to the gym to build muscle. You have to make regular use of that muscle to make progress, though overdoing it might lead to injury.

To build a strong credit history, you must use credit regularly, but in a responsible way that doesn’t get you in over your head. In other words, the more you show you can be trusted to take on debt obligations and repay those obligations on time, the more likely lenders are to want to lend to you in the future.

You can use various financial products to build that strong credit history, including credit cards, mortgages, car loans and personal loans. Here, we’ll focus on how to use personal loans to rebuild your credit, but we’ll also touch on the alternatives and how they compare to the personal-loan option.

How can a personal loan improve your credit?

Here are four ways you can use a personal loan to help build your credit history:

  1. Establish a pattern of on-time payments. Personal loans generally have a fixed payment schedule, which makes the payments easy to budget for. You can set up automatic debits to ensure that you’re making those payments on time every month, and that behavior will count favorably toward your credit score.
  2. Consolidate debts. You can use a personal loan to consolidate other debts. If you use a personal loan to pay off credit card balances, that can help your credit utilization rate, which is the second-most-important factor in your credit score. On top of that, consolidating your debts into one loan can simplify your repayment obligations, potentially reducing your chances of missing a payment.
  3. Lower your interest rate. The average interest rate on a two-year personal loan was 10.13 percent as of the second quarter of 2017, which seems like a bargain compared with the average credit card interest rate at the same time: 14 percent. The truth is, if you don’t have good credit, you probably won’t get a rate as low as 10.13 percent on a personal loan. Then again, your credit card rate would probably be greater than 14 percent. The point is, personal loan rates are generally lower than those associated with credit cards, so shifting debt from cards to a personal loan can lower your interest rate. This can make it easier for you to pay off your debt and improve your credit score as a result.
  4. Diversify your credit mix. One factor that goes into determining credit score is the types of credit you have. Ideally, you’ll have experience with both revolving credit (typically, credit cards) and installment loans (which include personal loans). If you don’t already have installment debt such as a mortgage or a car loan, using a personal loan to manage some of your debt would diversify your credit mix. The nature of your credit mix accounts for just 10 percent of your credit score, but when it comes to improving credit, every little bit helps.

Not only have personal loans grown in popularity over the last several years, the more than 16 million Americans with such loans, according to the credit rating agency TransUnion, are handling them relatively well: The delinquency rate on personal loans recently reached a new low, according to September 2017 data from TransUnion. Despite that growth, a personal loan isn’t a good choice for everyone.

Could taking out a personal loan backfire?

Before you apply for a personal loan, it is important to know some of the things that could go wrong:

  1. New credit applications could hurt your credit score. Though it’s a relatively minor factor, applying for and taking on new credit can ding your credit score in the short term.
  2. Fees could outweigh any interest rate advantage. Shifting debt from credit cards to a personal loan may reduce your interest expense, but watch out for the fees involved in taking out a loan. To learn more about personal-loan traps to avoid, check out this article from MagnifyMoney, a LendingTree subsidiary.
  3. Debt consolidation can become a gateway to more spending. Shifting credit card debt to a personal loan makes sense only if you’re reining in your spending so you don’t rack up even more debt.
  4. None of this works if you can’t make your payments. Before you borrow, make sure that loan payments fit your budget, and that you are organized enough to make payments on time. If you can’t stick to a plan to pay off the loan, getting one will do your credit score more harm than good.

Is it smart to use a personal loan to build credit?

A personal loan can make your debt easier to manage, can be more cost-effective than a credit card and does not involve the long-term financial commitment of a car loan or a mortgage.

However, interest rates on personal loans are typically higher than on car or home loans, and monthly payment obligations are less flexible than with a credit card. Depending on your credit history, it might be hard to get approved for a personal loan. And if you’re very disciplined, you could actually use a credit card to build your credit without going into debt.

The value of a personal loan depends on how you use it. Never take out a loan without a specific purpose in mind, and make sure that the loan is the most cost-effective way to accomplish that purpose. Also, never take on debt without a clear repayment plan. Ultimately, that will determine whether a personal loan is the best choice for improving your credit.

How to get a personal loan to build credit

By now, you might have spotted a certain catch-22 involved in building credit: You have to use credit to improve your credit history, but it’s hard to get credit if you don’t have a good history.

It may be harder to get credit without a strong track record, but it is not impossible. There are personal loans designed for people with bad credit who want to improve it. Once you’ve found a product you can qualify for, prioritize making payments on time and be patient: It can take years to build good credit. If you have had previous credit problems, avoid adding any new problems and your negative history will start to fade further into the past.

If you’re set on getting a personal loan to build your credit, talk to a few lenders to get a sense of what your options are and what factors might help someone with shaky credit get a loan. Here are some issues to discuss:

  1. Secured vs. unsecured loans. If you have something of value that can be used as collateral, see if it might make the difference in getting approved. If so, it might be worth doing just to establish a positive enough repayment record to qualify for an unsecured loan next time.
  2. Employment history. If you don’t have a long history of using and repaying credit, perhaps you can point to a stable job record. In particular, if there are no long gaps in your work history and you have been with your current employer for at least two years, it should be viewed as a plus.
  3. The impact of size. Try to avoid turning conversations with a lender into a purely yes-or-no proposition. If they don’t think you can qualify for the size of the loan you had in mind, find out whether a smaller loan is a possibility. Because debt-to-income ratio is a crucial component of approval, asking for a smaller loan (and, as a consequence, incurring less debt) could help. According to TransUnion, the average debt owed by personal loan borrowers in the second quarter of 2017 was $7,781, so if you shoot for less than that, you may improve your chances.
  4. Term length. Another risk factor for lenders is the length of the loan. The faster a loan can be repaid, the less risky it is to the lender, so see if a short-term loan might make them more willing to give you a shot.
  5. Lending guidelines. Don’t pay much attention to advertisements that are not specific to your situation. Once you’ve talked to a lender about you and your situation, find out whether and under what circumstances they make loans to people like you. There is no point in continuing the conversation with a lender whose minimum standards are way beyond your reach.
  6. Credit reporting. Banks and mainstream lenders should report to the three major credit reporting agencies (Equifax, Experian and TransUnion), but there are more off-the-grid sources of credit, from local payday lenders to online peer-to-peer lending networks, that often do not. Remember, the goal here is not just to get a loan, but also to use that loan to improve your credit history, so you want to make sure you are working with a lender that reports to the major credit agencies.
  7. Co-signers. A possible solution is to get someone with good credit to co-sign a loan. Obviously this is a big commitment — it means someone is willing to take a risk on you, and you have to come through or it will jeopardize your relationship with that person and their credit. However, if you can convince someone that you are on top of your finances and just need a chance to build your credit history, this might be the best way of getting the opportunity to do so..

Once you know all the facts, budget before you borrow. In this way, you can be confident that the loan is a commitment you can live with, and if possible automate your loan payments via automatic withdrawals from your checking account to ensure that you follow through on that commitment.

Why is it so important to have good credit?

There are several reasons why your credit is important even if you don’t plan on being a frequent borrower:

  1. More financial flexibility with more credit availability. Even if you are able to live within your means under most circumstances, there are times — such as in the case of a major purchase or a financial emergency — when having access to credit could help you plug a temporary gap.
  2. Lower borrowing costs. When you do need to borrow money, better credit will allow you to take advantage of lower interest rates.
  3. Improved chances of employment. Some employers review applicants’ credit history as part of the hiring process, particularly when the job in question involves handling money.
  4. Broader housing options. Some landlords, especially in big cities where rentals are in high demand, consider credit history when deciding who they want as tenants.
  5. Lower insurance rates. Your auto insurance company is also likely to use credit score as a factor in deciding your insurance rate.

Alternative ways to build credit

You do have alternatives for building credit besides personal loans. Here are some possibilities:

Credit cards. Though more expensive than personal loans, on average, credit cards give you more flexibility in the pace at which you borrow and pay back money. Keep in mind: You do not have to go into debt if you’re using a credit card to build credit: You can charge small amounts to the card and pay off the balance every month. That way, you won’t incur any interest charges.

One way to get started is with a secured credit card, which allows you to access a line of credit after making a deposit with the credit card company. (The deposit secures your line of credit.) You can read about credit cards for bad credit here.

Car loans. If you need a car anyway, perhaps the best way to establish credit is through a car loan. While having bad or no credit can make it difficult to find affordable financing for a car, it’s not impossible. Be sure to compare compare terms from different lenders before applying and make sure the costs of borrowing make sense in the long term.

As for other ways to build credit, they’re out there, but they may be less reliable than a personal loan, a credit card or a car loan. For example, you could ask someone to add you as an authorized user on his or her credit card, get someone to co-sign a loan with you, or see if you can get your landlord to report your rent payments to the major credit bureaus.

Ultimately, the best choice depends on your situation, but in each case the advice remains the same: Borrow only what you truly need, and not more than you can repay.

Are personal loans the right way for you to build credit?

So, is a personal loan your best choice for building credit? That comes down to whether you are ready to meet the payment commitments for a personal loan. Can you envision a budget over the length of the loan that will leave ample room for the monthly payments? Also, is your employment situation stable enough that you can be confident in maintaining your income over the length of the loan term?

If you can answer yes to both of those questions, you might benefit from using a personal loan to build or rebuild credit. Before you apply, do your best to find the best terms by comparing personal loans and lenders through LendingTree.

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