Personal loans have many benefits – they’re versatile, often come with a high borrowing limit, and you can use a personal loan to build credit.
However, to secure a personal loan with a good interest rate and terms, you typically need a strong credit score and a steady source of income. If you have no credit or poor credit, you might consider another borrowing option, like a credit card or a credit builder loan.
How a personal loan can improve credit
If you’re wondering, “do loans build credit?” The answer is they can! To understand how a personal loan can improve your credit, it helps to know how your credit score is calculated. A FICO® credit score is composed of the following five variables:1,2
- Payment history (35%)
- Credit utilization/amounts owed (30%)
- Length of credit history (15%)
- Credit mix (10%)
- New credit (10%)
A personal loan can potentially help improve your credit in the following ways:
- Reporting positive payment history: Your payment history accounts for the largest portion of your credit score. When you take on a personal loan, many lenders will report whether or not you make your payments on time. Your creditor might report to one or all of the credit bureaus – Equifax, TransUnion, and Experian. Making your personal loan payments on time each month can help build a positive payment history.
- Lowering credit utilization: Credit utilization is how much of your available credit you are using. A high credit utilization ratio can signal an inability to manage credit and negatively impact your credit score. Using a small portion of your available credit and paying it off in full each month shows lenders you can adequately handle credit and can improve your credit score. Taking on a personal loan can reduce your credit utilization ratio by increasing your available credit.
- Broadening credit mix: Lenders like to see that you can handle a mix of credit accounts, including credit cards, a line of credit, a mortgage, or a personal loan. If you only have a credit card or two, adding a personal loan can help diversify your credit mix and potentially improve your credit score.
Tips for building credit with a personal loan
If you’re looking for simple ways to build your credit with a personal loan, consider the following tips:
- Pay your bills on time. Since your payment history accounts for the largest portion of your credit score, aim to make your personal loan payments on time.
- Don’t use all of your available credit. Try to keep your credit utilization low to demonstrate that you can manage your credit and not overextend yourself.
- Build your credit mix. Lenders like to see that you can manage various credit products. If you only have credit cards, consider adding a personal loan or line of credit to the mix.
- Only apply for new credit when you need it. Each time you apply for new credit, a hard inquiry is performed, which can reduce your credit score by a few points.
- Avoid closing old accounts. Even if you don’t use an old credit account, consider keeping it open so you don’t shorten your credit history.
What to consider before using personal loans for building credit
While there are many benefits associated with taking on a personal loan to build credit, there are also several important considerations, including:
- A late payment on a personal loan can damage your credit. While on-time payments can help to improve your credit score, late or missed payments on a personal loan can damage your credit score. If your payment is more than 30 days late, it will typically end up on your credit report and can damage your score.3 If you default on your personal loan, lenders can send you to collections after you to try to get their money. If you have a secured personal loan, you risk losing the asset you put forward as collateral.
- Bad credit and no-credit personal loans often come with high costs. While finding a personal loan with bad credit or no credit is possible, you can expect to pay a high interest rate and fees. Lenders typically charge a higher rate because you’re considered a high-risk borrower. Before taking on a bad credit or no-credit personal loan, make sure you understand the total cost, including fees.
- Short-term loans can lead to a cycle of debt if not repaid on time. You might be considering a short-term loan, like a payday loan if you need fast access to cash. However, these loans pose a serious risk if you can’t pay them back on time. Many short-term loans only give you two weeks to a month to repay the money.4 You’re often charged additional fees if you can’t make your payment. Plus, these loans can come with extremely high interest rates and fees, making it difficult to get out of debt if you fall behind on your payments.
- Not all personal lenders report to major credit bureaus, potentially limiting the impact on your credit. Lenders are not required to report to the credit bureaus.5 They can report to a single credit bureau, multiple bureaus, or none at all. If you want to build your credit score, confirm if the lender will report your payment information before applying for the loan.
- Applying for a personal loan will require a hard credit check. Any time you apply for new credit, you can expect a hard credit check (also called a “hard inquiry”). This can cause your credit score to drop by a few points, but only temporarily.
Exploring alternative routes for building credit
Are personal loans worth it? It depends on your particular needs, wants, credit score, and financial situation. If you’re not sure a personal loan is the right choice for you, there are other options.
Apply for a credit builder loan
Credit builder loans are specifically designed for borrowers with no credit or bad credit. With a credit builder loan, instead of receiving a lump sum payment upfront and then using that money, the process works in reverse. The lender puts the money into a savings or certificate of deposit account. You make monthly installment payments. You get access to the money when you’ve made the final payment. The benefit of a credit builder loan is that they report to the credit bureaus, which can help increase your credit score.
Apply for a secured credit card
A secured credit card requires a cash deposit before you can use it. The cash deposit is typically equal to your credit limit. For instance, if you deposit $200 to your account, you have a credit limit of $200.
With a secured credit card, you use your own money to cover each transaction. A secured credit card is similar to a debit card in that you can’t spend more than you’ve deposited. The benefit of a secured card is that your payment information is reported to the credit bureaus.
Become an authorized user
If you have a friend or family member willing to add you to their credit card as an authorized user, this can help you build your credit.
As an authorized user, you are not responsible for a late or missed payment, but you can use the credit card to make purchases. If the primary credit holder has a strong history of on-time payments, this can help you build your credit score over time.
Being added as an authorized user can lower your credit utilization ratio as it gives you more access to available credit. Before using this strategy, confirm that the lender reports authorized users to the credit bureaus.
Will you use a personal loan to build credit?
There are many reasons to take on a personal loan, including credit building. If you can secure a personal loan with a good interest rate and terms, you can use it to help build your credit. However, if you have a low credit score or you’re just starting to build your credit, you might find it challenging to qualify for a personal loan with a reasonable interest rate.
For more information on how to get a personal loan, check out our step-by-step guide for how to apply for a personal loan.