How To Build Credit With a Personal Loan
Updated: September 26, 2023
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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.
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.
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.
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.
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.
A credit card can help improve your credit score because it makes for a more diverse credit portfolio than simply sticking to loans. However, you must manage your credit cards well, consistently making monthly payments on time and in full.
You can get a copy of your credit reports from the three reporting bureaus (Equifax, TransUnion and Experian). You can request a copy from AnnualCreditReport.com free of charge.
The ideal situation is to strike a balance and pay off your significant debts while putting money aside for emergencies.
To help you out, you can apply debt management strategies like the Snowball Strategy or Avalanche Method. The more debts you pay off, the more flexibility you have to start putting more towards your savings.
Several factors affect your credit score. For example, FICO looks at five areas when calculating it. These are payment history, credit utilization ratio (or amount owed), length of credit history, new credit and credit mix.
It’s best to inform each credit bureau that shows the error immediately if you notice any. Equifax, Experian and TransUnion have their respective processes, so it’s best to get specific information. You can find this on their respective websites.
You can send your dispute by mail by filling out a dispute form (if necessary) and submitting a written explanation of the error. It's best to include documents that support your claim. You can send everything to the address that appears on your credit report.
However, if you find this too tedious, you can use other channels to dispute your credit report, such as by phone or online.
sources
- 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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