Building Credit With Personal Loans: How Does It Work?
Getting a personal loan to build credit can be an effective strategy. You can use a personal loan to positively impact several areas affecting the computation of your credit scores, such as payment history, credit utilization ratio and credit mix. However, it may have the opposite effect if you don’t manage the debt well.
Your credit score may influence more areas in your life than you realize. It can affect your insurance premiums and interest rates. It may even determine whether or not you get that apartment you’ve been eyeing.
Having poor credit standing makes it more challenging to qualify for certain things. Insurers are likely to charge a higher premium and although you might still get approved for a loan with a less-than-stellar credit score, be prepared to pay higher interest.
The advantage of a personal loan is its versatility — you can use it for almost anything, even to build credit. Responsibly managing debt can help you establish a good payment history, assuming you consistently make payments on time.
However, building credit with a personal loan isn’t the best move for everyone. Review your situation before making a decision. If you aren’t careful, you could end up with more debt than you can handle, which will be detrimental to your credit standing.
A personal loan can help you establish a good payment history, reduce your credit utilization and improve your credit mix. All these may result in boosting your credit score.
Using personal loans to build credit has potential risks. It’s a debt you must manage, and you may run into fees that may make things more challenging for you.
A personal loan isn’t the best option for everyone. Fortunately, you have other options, such as peer-to-peer and credit-building loans.
How Does a Personal Loan Build Credit?
Building good credit starts with understanding the logic behind your scores. According to Experian, FICO scores in the U.S. increased from 710 in 2020 to 714 in 2021. FICO score uses data from credit reports and assigns different levels of importance to various areas, such as:
- 35% — payment history
- 30% — credit utilization (how much of the credit extended you’ve used)
- 15% — length of credit history
- 10% — new credit
- 10% — credit mix
Taking out a personal loan may seem counterintuitive since it adds another debt you must pay. However, it can work to your advantage if you manage it well.
Establishing a positive payment history can do wonders for your credit score. You can achieve this by consistently making timely payments on your loan. Although missing one or two deadlines won’t automatically kill your score, it’s best to avoid these.
Making regular payments reflects your ability to manage your finances responsibly. The longer you can sustain this behavior, the better your credit score can become.
However, even if you pay your debts 100% on time, it doesn’t guarantee you will achieve a stellar credit score. Remember, it’s only one of the areas FICO considers.
Mortgages, credit cards and auto loans are different types of credit. FICO refers to the different kinds of debt you hold as your credit mix, and the mix accounts for 10% of your credit score calculation.
Credit diversity can affect your credit score positively, especially if you don’t have an extensive credit history. Ideally, it's best to have a mix of revolving and installment credit, indicating that you can manage different types of debts. A personal loan helps you achieve this, and when you combine this with good payment history, you become less risky in the eyes of lenders.
Another factor affecting your credit score is your credit utilization ratio, which is how much of your credit you’ve used. For example, if you have a $25,000 limit on your credit card and use $3,000, your credit utilization ratio is 12%.
It’s wise to keep your ratio below 30% by paying your balances on time and in full. That’s where a personal loan can help. On average, Americans use three or four credit cards simultaneously. You can use a personal loan to consolidate credit card debt, pulling your ratio down.
How Can a Personal Loan Hurt Your Credit?
A personal loan can help build credit in several ways, assuming you use it strategically and manage it well. However, it’s not entirely risk-free. There are potential consequences to opening a personal loan to build your credit.
A personal loan, regardless of the amount, is a commitment. Taking a good hard look at your current financial situation can help you determine whether you’re in the position to pursue one or not. Remember, once your personal loan is approved, you must build it into your monthly budget to ensure you make your payments on time.
Before deciding, it’s best to use caution and explore your options thoroughly since taking out a personal loan may not be the best choice for everyone. If you’re not careful or your current circumstance doesn’t allow you to use it to your advantage, it might negatively impact your credit score.
Whether your loan amount is $5,000 or $50,000, it’s still a form of debt. Using it to pay off existing obligations is a good idea, but it doesn’t erase the fact that you’re still taking on new debt.
Evaluating your financial situation is an excellent way to determine whether a personal loan can bring more benefits or drawbacks. Remember, coming up with the monthly payment might be possible, but it may require you to adjust your spending in other areas. You must be comfortable with these changes. Otherwise, it will become harder for you to sustain your finances.
Beyond the actual amount you borrow, you also need to think about the fees associated with taking out a personal loan. Although these may be minor in comparison to the loan balance, you may receive a lesser disbursement than you anticipated.
Take an origination fee, for example. It’s a one-time amount deducted from your proceeds. Some personal loan lenders don't charge one. However, other lenders may charge an origination fee that is a percentage of your loan amount. For example, if you borrow $10,000, you may only receive $9,200. The difference may be crucial, especially if you only borrow what you need.
Comparing quotes from multiple lenders is an excellent strategy if you're considering taking out a personal loan. Although most initiate soft credit inquiries during pre-qualification, they’ll conduct a hard inquiry if you proceed with your application.
A hard inquiry may lower your credit score by less than five points. Borrowers with very good or excellent credit standing won’t feel it so much, but you can’t say the same for those whose credit scores are low or fair.
You can’t eliminate the effects of a hard inquiry, but you can minimize them by avoiding multiple personal loan applications within a short period.
Key Notes When Using a Personal Loan to Build Credit
If you’re entertaining the idea of using a personal loan to build credit, keep the following in mind:
- Always compare rates and offers: Don’t settle for the first lender you encounter when shopping for a personal loan. Different providers offer varying rates, so taking the time to gather quotes and offers can help you find the best deal.
- Borrow only what you need: There’s a lot of value in only borrowing what you need — after all, why put yourself under more financial obligation if you don’t have to? A higher loan amount may give you more financial flexibility in the short term, but you’ll need to find a way to pay it off.
- Know the monthly payment you can afford: Establishing a positive payment history is crucial for building credit. Quotes from personal loan lenders will give you an idea of how much you’ll need to pay per month. Make sure it’s something you can afford. Otherwise, you’ll leave a balance that not only subjects you to potential fees but also impacts your credit score.
- Read the fine print of the loan: Your monthly cost may be your primary concern. But don’t forget to read through the fine print. It may contain clauses about fees or penalties that could affect your interest (and, in turn, your monthly payment amount).
- Make consistent and timely payments: It isn’t simply about paying your monthly obligation in full. Even if you pay the appropriate amount but regularly do so after the due date, it won’t help you build credit.
Alternative Options for Building Credit
Building credit with personal loans can be a good strategy, but it isn’t the only option for you. You can explore several alternatives if your financial situation isn’t ideal for it or you aren’t comfortable with the terms you find.
As the name implies, lenders designed these loans to help you build credit. A credit-builder loan doesn't disburse the loan amount to you immediately. Instead, your lender puts it in a locked savings account.
Depending on your loan terms, you’ll make regular monthly payments until you've covered the entire amount. In the meantime, your lender reports it to the three credit bureaus, causing your credit standing to improve. You’ll receive the amount when the loan terms are over, plus any interest earned.
A secured credit card typically requires collateral, usually a security deposit. Your credit line is also usually limited to the same amount. Borrowers with less than favorable credit scores are more likely to be approved for a secured credit card since they can lose their deposit if they miss payments.
The possibility of losing your collateral usually incentivizes you to make your monthly payments. When you make regular payments, it can help boost your credit score.
You can also consider peer-to-peer loans to help you build credit. Unlike traditional loans, which go through credit unions or banks, your proceeds come from other individuals and entities willing to lend you funds (which is why they’re called peer-to-peer).
Over the years, the number of lenders and borrowers has increased due to lending groups becoming less restrictive. A P2P loan will usually offer you a lower interest rate than traditional loans, making it easier for you to make your monthly payments. In turn, it could help you increase your credit score faster.
Frequently Asked Questions About Building Credit
The thought of building credit with personal loans raises questions. MoneyGeek answered those that borrowers most commonly asked. These may help you decide whether or not this is the best move for you.
- Experian. "What is the Average Credit Score in the U.S.?." Accessed June 9, 2022.
- Experian. "What its the Average Number of Credit Card per US Consumer?." Accessed June 10, 2022.
- MyFico. "Credit Checks: What are Credit Inquiries and How Do They Affect Your FICO Score?." Accessed June 10, 2022.
- In Charge. "How Does a Credit Builder Loan Work?." Accessed June 10, 2022.
- Debt.org. "Peer-to-Peer Lending." Accessed June 10, 2022.
The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.
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