Many people who need to take out a personal loan to cover expenses often worry that doing so could damage their credit score. Instead of asking whether personal loans harm your credit, you should ask yourself, “Can a personal loan help my credit?”
Taking out a personal loan can actually allow you to build credit. And that’s important because credit helps you whenever you need money. For example, if you need a loan to buy a car or you need a credit card to purchase items that you can pay for later, having credit allows you to do that.
So, how do personal loans build credit? By consistently making timely payments, you demonstrate reliability to credit bureaus, which can boost your credit score. This improved score can open doors to more favorable interest rates and loan terms in the future.
Additionally, having different types of credit, like installment loans and credit cards, can further enhance your creditworthiness. So, a personal loan helps you cover immediate expenses and strengthens your financial foundation, ensuring you’re well-prepared for future financial needs.
- What is a personal loan?
- How can taking out a loan help build credit?
- Risks to using a personal loan to build credit
- Alternatives to personal loans for building credit
- Tips for improving your credit score
- Key takeaways: Building your credit with a personal loan
What is a personal loan?
A personal loan is money borrowed to pay for personal expenses. Unlike car loans, mortgage loans, or student loans, which limit what a loan can be used for, personal loans allow borrowers to use their money however they want.
Personal loans, which can be taken from an online lender, bank, or credit union, are expected to be repaid in small portions over time with interest added on. These loans are often unsecured, meaning borrowers are not required to offer collateral (such as a house or a car) to secure their loan. However, there are many different types of personal loans, so consider your needs and goals to find the best one for you.
How can taking out a loan help build credit?
There are many reasons you might want to take out a personal loan, but at the end of the day, you should always ask yourself, “Will a personal loan help my credit?” Taking out a personal loan can help build your credit score–but only if you repay it on time and in full, which can positively impact your credit. On the other hand, if you are late with payments or fail to repay the loan at all, your credit score will suffer.
So, how do personal loans build credit? Some of the different ways a personal loan can improve your credit profile include:
Increases credit history
Credit history measures your ability to repay debts and your demonstrated responsibility in repaying them. This is then recorded in your credit report, which details the following:
- Number and types of credit accounts
- How long each account has been open
- The amounts you owe
- The amount of available credit used
- Whether your bills are paid on time
- The number of recent credit inquiries
When you take out a personal loan, you begin to build a history of credit. If you have a long credit history, you come across as a borrower that lenders and credit bureaus can trust. This can help you get approved for future loans.
Improves payment history
When it comes to credit, you want to build trust. Payment history accounts for 35% of your credit score–the largest percentage. When a lender trusts a borrower to repay the money they’re providing, the personal loan works, and the borrower’s credit grows more and more solid. As long as borrowers repay their loan’s monthly payments on time, they’ll build that trust with the lender, which will lead to a better credit and payment history.
Reduces credit utilization
Credit utilization ratio, 30% of your credit score, is the money you owe on your credit cards, divided by your total credit card limit. For example, if you have a $1,000 balance on a credit card with a $2,000 credit limit, you have used half your available credit, meaning your credit utilization is 50 percent. This ratio is something that credit reporting agencies can use to determine how well you’re controlling your finances.
The best way to reduce your credit utilization ratio? Pay off your debts and balances every month. You can use a personal loan to accomplish this by paying off your debts with the money you receive from the loan–and then by paying off the personal loan in a timely manner.
Adds to your credit mix
A credit mix is the types of different credit accounts you have, such as credit cards, loans, mortgages, and others. Credit mix is often considered when determining your credit score, as most FICO scores will use it to account for about 10% of your overall credit score, so it’s good to have a mix of credit.
However, just because a credit mix can help your credit score, it’s not recommended that you apply for more loans or credit cards just to improve it. Opening loans and credit cards you don’t need can negatively affect your credit score. Only take out a loan or open a credit card if you need to as accumulating credit card debt will result in a low credit score.
Risks to using a personal loan to build credit
Does getting a loan help your credit? It can, but you should never take out a personal loan to improve your credit score if that’s your only goal, especially because applying for a personal loan can impact your credit profile. As we mentioned, one risk to opening a personal loan to build good credit is that doing so unnecessarily can actually damage your credit score.
There are other risks to consider as well, including:
Hard inquiry when applying for a loan
When you apply for a loan, a process goes on behind the scenes. The lender from which you’re requesting the loan will ask to review your credit report as part of the application process. When this happens, it may be recorded on your credit report as a “hard inquiry,” which is basically a timeline of when you have applied for new credit. A hard inquiry will usually impact your credit score for a year, but it can stay on your credit report for up to two years.
Adding to debt
If your goal is to break bad money habits, getting a personal loan may not be the best choice, especially if you don’t necessarily need one. Sometimes, personal loans are needed to pay off certain debts or expenses. However, this means you now have another debt to pay off that you’ll need to include in your financial budget. Even if you’re using a personal loan to pay off another debt, you still also have to pay off the personal loan on time.
Related fees
Nearly any loan you take out–whether personal, mortgage, auto, or student–will have extra fees associated. While this is common, not all fees are the same. Be sure to read your loan terms closely to determine exactly how much in fees you’ll pay on the loan. If necessary, compare lenders because some offer lower fees that may be more affordable.
Failure to make payments or defaulting
Taking out another loan increases your risk of not making payments or defaulting on the loan altogether. Interest can add up, especially when you miss payments. Unfortunately, unforeseen circumstances, such as the loss of a job or unexpected medical expenses happen, and having another loan can be a burden if these situations occur.
Of course, this is a risk everyone takes with any loan or line of credit. However, your credit score can be negatively impacted if you make late payments or default on the loan.
Alternatives to personal loans for building credit
Keep in mind that taking out a personal loan to improve your credit score is never a good idea. A personal loan may be necessary to repay large debts and consolidate debt, pay for expensive items, and help you manage your bills when times are tough, but taking out a personal loan for the sole purpose of building credit should be avoided. After all, there are other ways to build credit, each with their own benefits and risks.
Credit-builder loan
A credit-builder loan is a type of personal loan designed to help you build or improve your credit score. Unlike regular personal loans, where you get the money upfront and repay it over time, a credit-builder loan gives you the money only after you have paid off the total amount.
With a credit-builder loan, the loan amount is kept in a secured account by the lender. You make regular payments until the full amount is paid off. Only then do you receive the funds.
The main benefit of a credit-builder loan is that it helps improve your credit. Each on-time payment is reported to credit bureaus, helping you build a positive payment history, which is a big part of your credit score. This can be very helpful if you have no credit history or want to rebuild your credit.
Report alternative payments
Many people are unaware that their phone, cable, and internet service providers can report your payments to credit bureaus–all you have to do is ask! Doing so can help establish and build good credit without the risks associated with taking out a loan or opening a credit card–as long as you’re making these provider payments on time, of course.
Joint account
By authorizing another user on a credit card or having a co-signer on a loan, you’re now splitting the payment responsibility between you and someone else (generally a family member). This means that only one person is required to make the monthly payments–and as long as that is done on time and regularly, both people benefit. However, the lender or credit card company holds both people accountable if payments are not made on time and regularly.
Credit cards
Did you know that there are two types of credit cards? Secured and unsecured. A secured credit card requires a cash security deposit when you open the account, which reduces the risk to the credit card issuer. If you fail to pay your bill, the credit card issuer will take the money from your deposit to cover the payment. Secured credit cards are usually good options for those with bad or no credit.
By using a secured credit card responsibly (making payments on time), you can improve your credit to the point where you may qualify for an unsecured credit card. Keep in mind that secured credit cards often come with higher interest rates, so it’s best to pay off as much as you can each month to avoid interest charges piling up.
On the other hand, an unsecured credit card does not require a cash deposit upon opening. Because they’re a larger risk to the card issuer, applicants must have average or above credit scores to receive an unsecured card. If you qualify for an unsecured credit card but don’t have great credit, be on the lookout for high fees.
Tips for improving your credit score
There are many ways to improve your credit score without taking on debt. Here are some tips:
- Pay bills on time: Always pay your bills by their due dates to build a positive payment history.
- Check your credit report: Look for errors on your credit report and correct them to avoid mistakes that might hurt your score.
- Reduce outstanding debt: Pay down your debt to improve your credit utilization ratio. Focus on high-interest debt first or pay off smaller balances quickly.
- Maintain low credit balances: Keep your credit card balances low compared to your credit limits. Aim to pay off your balances in full each month or keep them as low as possible.
- Avoid closing old credit accounts: Keep older credit accounts open to maintain a longer credit history, which benefits your credit score.
- Limit new credit inquiries: Only apply for new credit when necessary. Each hard inquiry can lower your credit score slightly, and multiple hard inquiries in a short time can be a red flag for lenders.
- Diversify your credit mix: Use different types of credit to show lenders you can manage various types of credit responsibly.
Key takeaways: Building your credit with a personal loan
As you can see, there are many ways to build your credit score. Taking out a personal loan is one of them because paying your monthly loan payments on time allows you to establish a credit and payment history while proving to lenders and credit bureaus you’re a trustworthy borrower.
Sun Loan is here whenever you need a personal installment loan. Throughout our 30-year history, our friendly and professional loan specialists have been helping people with personal installment loans and ensuring they have an affordable payment plan that fits their needs. Other lenders? They’re only interested in credit scores.
Our team is ready to assist you with financial decisions by providing a monthly budgeting overview and helping you understand your credit score so you can successfully make on-time payments, establish your credit history, and build your credit score. Stop by one of our local branches, call us at (800) SUN-LOAN, or apply online.
