Using a Personal Loan to Build Credit: Pros and Cons
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Personal loans are a flexible financial product. You may use them to cover a major purchase, handle an unexpected medical bill or consolidate or refinance your debt. But personal loans can do more than provide you with a lump sum of money, it could help you improve your credit in various ways, such as by:
- Allowing you to build a history of on-time payments
- Reducing your credit utilization ratio through consolidation or refinancing
- Diversifying your credit mix
However, taking on debt comes with its risks. Let’s examine the pros and cons of using a personal loan to build credit, and what steps you could take to find competitive terms and rates.
How a personal loan can help you build credit
- Payment history: This factor makes up 35% of your score. Pay your bills on time and watch your credit score rise.
- Credit utilization ratio: This number represents your amount of debt versus your available credit and makes up 30% of your credit score.
- Length of credit history: Representing 15% of your score, this number looks at how long you’ve had the open accounts shown on your credit report.
- New credit: Making up just 10% of your total credit score, opening new accounts can cause your credit score to drop by a few points. Likewise, credit inquiries can also temporarily reduce your score.
- Diversity of accounts: Lenders want to see that you manage a variety of credit responsibly, including revolving debt like credit cards, and installment loans, such as an auto loan, mortgage or personal loan. This also makes up 10% of your credit score.
With these factors in mind, you can begin to see how a personal loan may help you build credit. Here are specific examples to consider:
- If your credit is poor because you are carrying high balances on high interest credit cards, you could consolidate your debt with a personal loan. Once you pay off your credit cards, your debt-to-available-credit ratio will shrink, raising your credit score.
- Continue making on-time payments on your loan while keeping those credit card balances zeroed out, and your credit utilization ratio will continue to drop while your on-time payment history grows.
- Opening a personal loan may expand your credit diversity, which is also good for your score.
As long as you make your payments on time and don’t overextend your credit in other ways, a personal loan can have several positive effects on your credit score.
Pros vs. cons: Using a personal loan to help build credit
Whether you’re looking to repair your damaged credit or establish a positive credit history for the first time, a personal loan could be a viable option if you can manage your money responsibly.
However, you shouldn’t take out new debt simply to improve your credit score. You should have a plan for the money you borrow, such as to pay down debt.
Further, a personal loan may not make sense if you’ll end up with a high interest rate, or if you’ll be unable to reliably make payments throughout your loan term. Safe to say, you’ll want to research lender terms, fees and rates carefully before committing.
- Unsecured personal loans have fixed monthly payments which can help you budget better.
- Personal loans can add to your credit mix, which allows you to show lenders that you know how to juggle different types of debt.
- Personal loans, even for people with lower credit, may come with lower interest rates than on credit cards.
- If you use a personal loan to pay off high-interest credit card debt, you run the risk of charging up your cards again and ending up in worse financial trouble.
- Personal loans for people with lower credit may carry high interest rates that make repayment difficult, however, these interest rates could be lower than those on a credit card.
- If you’re irresponsible during repayment, you could damage your credit score.
Finding a personal loan
You can get a personal loan from a bank, a credit union, or an online lender. Interest rates usually range from 6% to 36%, but if you have poor credit, rates can go as high as the triple digits. Other factors, including your total income and your overall debt, may also affect your interest rate and your ability to get a loan.
Many personal loans have no application fees, no origination fees and no prepayment penalties. Seek out lenders that make repayment affordable in these ways.
Create a list of lenders you prefer. Apply with those that offer preapproval. A preapproval gives you a glimpse into what terms you may expect to qualify for.
Review lender fees and conditions, plus the terms you receive after being preapproved, to see which is your favorite lender. Afterward, apply for your personal loan. This will require you to submit to a hard credit check.
4 other ways to build your credit
If you’re not convinced whether or not a personal loan is the best option for your needs, or your credit doesn’t allow you to qualify for reasonable terms, you may consider these other options:
- Tidy up your credit report. There may be errors or out-of-date information on your credit report. Getting these discrepancies removed or fixed may improve your credit score.
- Get a secured credit card, backed by a deposit. Use it for small purchases and make on-time payments every month to create a positive payment history.
- Speak to your creditors to negotiate payment arrangements if you’re struggling to keep up with bills. Negotiating for lower payments could mean you’re better able to make on-time payments.
- Ask for help. Enlist the help of a credit repair agency or credit counseling service to help you get your finances in order. These types of agencies offer a variety of services, from negotiating with creditors to helping you create a budget. Do your research to decide where you need the most assistance, and take your first steps on the path to a better financial future.
A personal loan may not be the best option for everyone looking to build credit, but it can help in certain situations. If you hit a rough patch but are typically disciplined with credit and just need a cash infusion to get your finances in order, a personal loan can help.