Do Personal Loans Build Credit? How They Help and When They Hurt
Personal loans can be a useful tool if you need to take care of a large expense, consolidate debt or handle an emergency. But, if you’re trying to build your credit history you may be wondering how a loan could help or hurt your credit score.
The answer depends on many different factors like if the lender reports to the credit bureaus, how the loan is managed, and if you have existing debt. Let’s take a look at some of the ways a personal loan can impact your credit.
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Do Personal Loans Build Credit?
Personal loans can help you build credit if you make on-time payments and the lender reports to the credit bureaus.
A personal installment loan provides an upfront, lump sum of cash that is typically repaid over time through scheduled monthly payments or another fixed payment schedule. If the lender reports to the credit bureau, your payments become a part of your credit profile. Here are two things to keep in mind:
Payment history. Payment history is the biggest factor that goes into calculating your FICO® Score. This means that a record of on-time payments can help you build a positive payment history.
Credit reporting. On-time payments will only help you build credit if your lender reports to the credit bureaus. When looking for borrowing options, you can check the lenders FAQs to see how and if they report.
How Personal Loans Can Help Build Credit
A personal loan can affect your credit in a few different ways. FICO® uses several different factors to calculate your score including payment history, amounts owed, length of credit history, credit mix and new credit. Understanding each category can help you understand how a personal loan can help you build credit.
Payment History
Payment history is typically the most important factor when it comes to creditworthiness. When you build a history of on-time payments, it shows lenders that you can manage debt effectively. When thinking about borrowing, it’s important to make sure the payments fit into your budget comfortably.
Credit Utilization Ratio
Your credit utilization ratio measures the amount of available credit versus the amount of credit you’ve used. This applies to types of revolving credit like credit cards and personal lines of credit.
If you have high balances, a personal loan can be used for debt consolidation, which can help you pay those balances off and lower your credit utilization which can have a positive impact on your credit score. Keep in mind that you’ll need to avoid spending on those credit cards until the new loan is paid off, or you’ll end up managing payments for new debt and new card balances.
Credit Mix
Credit mix refers to the different types of credit you manage. This includes revolving credit, like a credit card or line of credit, and installment credit, like an auto loan, student loan or personal loan.
If you have mostly revolving accounts, adding installment credit may help improve your credit mix, which can show lenders that you have experience managing different types of debt.
It’s not a major factor in your credit file, so you shouldn’t take out a new loan just to improve your credit mix. But, if you already need to borrow and can manage the payments, a personal loan may add variety to your credit file.
Risks of Using a Personal Loan to Build Credit
A personal loan can help you build credit, but it can also damage your score. Before you borrow it’s important to understand the risks and to make sure a loan fits into your budget and overall financial picture.
Late or Missed Payments
Though on-time payments on a personal loan can help build your score, missed or late payments can damage your credit score if the lender reports to the credit bureau. Even if the lender doesn’t report, if the debt is unpaid it can be sent to a collection agency that does. These can stay on your credit report and damage your score for years, which is why it’s important to make sure the loan works for your budget before you apply.
Hard Credit Inquiries
Some lenders run a hard credit check when you apply for a loan, which can temporarily lower your credit score. The impact is usually small, but applying for several loans in a short period of time can have a bigger impact. If you’re comparing lenders, look for one that lets you check your eligibility with a soft credit check, which won’t impact your score.
Overborrowing and New Debt
A personal loan adds new debt for you to manage and your debt to income ratio does have an impact on your score. Borrowing more than you need can make repayment difficult and it’ll increase the amount you pay in interest. Before accepting a loan offer, review the loan amount, interest rate, fees and payment schedule. Make sure the payment fits your financial situation.
Tips for Using a Personal Loan to Build Credit
If you decide a personal loan is right for you, there are a few things you should consider if you want it to help you build your credit:
Check whether the lender reports to the credit bureaus. Getting a new loan and making on-time payments won’t have an affect on your credit history if the lender doesn’t report to the major credit bureaus. Check the FAQs or call customer service before you apply to get the details on if and how they report.
Make every payment on time. Payment history has a big impact on your score. Consider setting up automatic payments or calendar reminders to help ensure you don’t miss a due date.
Borrow only what you need. A smaller loan amount will make repayment easier and can help reduce the amount of interest you pay.
Review the loan terms. Before you sign a loan agreement, make sure you understand all the terms and conditions.
Monitor your credit report. Checking your credit report can help you track your progress and catch possible errors. You can get a free credit report from each of the bureaus every 12 months.
When Does It Make Sense to Use a Personal Loan for Credit Building?
In general, you shouldn’t take out a personal loan just to build credit. A personal loan is debt, and it comes with interest and possible fees. However, if you already need to borrow and a personal loan fits into your budget it can help you build credit.
If you have no credit, limited credit or bad credit, personal loans offer an opportunity to establish creditworthiness. Just be sure you make each monthly payment on time.
If you need to consolidate high interest debt, using a personal loan to pay off high-interest credit card debt can improve your credit utilization ratio and overall credit score. For those looking to pay off a credit card balance or other debt with high interest rates, funds from a personal loan could help cover those balances. Your debt would then be “transferred” to one loan, ideally at a lower interest rate than your previous debt.
Alternatives to Personal Loans for Building Credit
A personal loan isn’t the only way to build credit. Depending on your credit profile and financial goals, another option may be a better fit.
Credit-Builder Loans
A credit-builder loan is a type of loan designed specifically to help you build credit. Instead of receiving the loan amount upfront, the money is usually held in a savings account while you make payments.
Secured Credit Cards
A secured credit card requires a deposit to open. The amount you deposit is usually your credit limit. You can make small purchases using the card and pay off the balance each month to help you establish a positive payment history.
Becoming an Authorized User
Becoming an authorized user means someone adds you to their credit card account. If the account is in good standing and reported to the credit bureaus, it may help your credit history. Keep in mind that the primary cardholder’s payment habits can affect your credit, and your use of the card can affect theirs.
Personal Lines of Credit
A personal line of credit is a form of revolving credit. If approved, you can borrow up to a set credit limit and draw funds as needed. As you repay the funds become available to borrow again. A line of credit may help build credit if the lender reports to the credit bureaus and you make on-time payments. Because it is revolving credit, your balance can also affect your credit utilization ratio. Keeping your balance low can help protect your credit profile.
Final Thoughts
Personal loans can help build credit when they’re used responsibly. If your lender reports to the credit bureaus and you make on-time payments, a personal loan may help you build positive payment history and add to your credit mix. However, if the loan isn’t managed properly, it can have negative consequences. Be sure to do your research and make sure a personal loan works with your unique financial situation before you decide to borrow.
DISCLAIMER: This content is for informational purposes only and should not be considered financial, investment, tax or legal advice.
