A personal loan provides you with extra capital to cover necessary expenses. These loans have a lot of versatility and could help your credit score. If you are considering a personal loan, you should know the impact it can have on your credit score. Like most financial products, personal loans are double-edged swords that can help or hurt your credit, depending on several factors.
What Can You Use a Personal Loan For?
You can use a personal loan to cover any expense. For example, some people take out personal loans for vacations and house remodels, while others use personal loans to consolidate debt or fund business operations. A personal loan is a catch-all financial instrument, but you can get more specific loans for certain investments, such as an auto loan for a vehicle or an SBA loan for small business costs.
Can You Use a Personal Loan to Build Credit?
You can use any loan or line of credit to help build credit. The major credit bureaus use several factors to determine your credit score, but payment history is the largest category, making up 35% of your credit score. Creditors report loan payments to the major credit bureaus. Making on-time payments for your personal loan may help improve your credit score. However, your credit score may take a hit if you fall behind on payments. Creditors will report late payments, but most of them will give you a grace period to address late payments before reporting them.
How Personal Loans Can Improve Your Credit Score
Using a personal loan to improve your credit score can be a good idea. These are some of the ways this financial product can help.
Impact of Personal Loans on Credit Mix
A traditional loan and any other financial product that involves capital can strengthen your credit mix. This component makes up 10% of your score. Having different types of debt will strengthen your credit mix. Personal loans are also a better alternative than bad options, like payday loans, for expanding your credit mix. It’s also important not to accumulate loans for the sake of your credit mix since you will get a hard credit inquiry for most loan applications.
Influence of Payment History on Your Credit Score
A positive payment history is one of the best ways to build credit. Making timely payments is 35% of your credit score. If you stay on top of your monthly loan payments and other financial obligations, it will have a positive impact on your score.
If you get a personal loan, make sure you can keep up with the monthly payments. Extending the loan’s duration or starting off with a lower balance will reduce how much you have to pay the lender each month.
The Role of Personal Loans in Credit Utilization
Loans can build up a positive credit history and indirectly reduce your credit utilization. A personal loan is not a credit product and will not impact your utilization ratio. However, you can use a personal loan to pay off some of your credit card debt. Consolidation can reduce your credit utilization and result in a higher credit score.
A better credit utilization ratio can make it easier to get new credit and better terms for various products like installment loans and home equity loans. Responsible credit habits can go a long way in strengthening your overall score.
Risk of Using a Personal Loan to Build Credit
Although you can help build credit with a personal loan, this method has several risks. You should only commit to a personal loan if you know the pros and cons and believe they are reasonable for your financial situation. These risks can sour the experience of using a personal loan to help build credit.
Monthly Payments
Even though payment terms can vary, typically, lenders will require monthly payments for your personal loan. These monthly payments will take up space in your budget and could restrict your ability to cover additional expenses. Some people can comfortably manage a personal loan’s monthly payments and other costs, but some may struggle with the extra expense. You can reduce your monthly payments by requesting less money or extending the loan’s duration.
High-Interest Rates
Lenders make money from loans by charging interest rates. An excellent credit score could get you access to lower interest rates, but borrowers seeking to build credit with a personal loan may receive higher interest rates. A higher interest rate can add additional dollars to the loan, depending on how much you borrow. If you are only using a personal loan to help build your credit score, you should ask for a lower loan amount. The payments will still get reported to the major credit bureaus, and you won’t owe as much interest.
Fees and Penalties
Fees and penalties can increase the total cost of your loan. Lenders could charge administration fees for creating the loan and could charge penalties for late payments or if you want to pay off the loan early. Some fees and penalties are avoidable, but you should look at a loan’s terms to make sure these extra expenses are reasonable.
Increases Your Debt Load
Taking out a personal loan will increase your total debt. Some households endure significant financial stress because they incur too much debt. The accumulating debt can take up a large percentage of their budgets.
A higher debt load could also hurt your chances of landing a mortgage or auto loan. Lenders don’t stop at your credit score. They also look at supporting metrics, such as your debt-to-income ratio. This ratio measures your debt against your income. Having too much debt could disqualify you from a loan even if you have a pristine credit history.
Late Payments and Default
Although a personal loan can improve your credit score, this financial product can also hurt your score if you fall behind on payments. Any late payment for your personal loan will show up on your credit report. Staying on time with personal loan payments can also strain your finances and make it more difficult to make on-time payments for your credit card and other financial obligations.
Credit Inquiries
Most financial institutions and credit unions run hard credit checks before giving personal loans. These credit inquiries will have a negative impact on your credit score and trim it by a few points. You can still get a new personal loan if you have a good credit score, but you shouldn’t get a personal loan leading up to an important purchase like a house or a car. Avoiding loans leading up to these purchases can preserve your FICO score.
It typically takes a few months to recover from a credit inquiry. A personal loan can be a good option for building credit if you are not applying for an important financial product for several months. However, a hard credit check does not guarantee approval. Borrowers with poor credit can go through a hard credit check and still get their applications rejected.
Personal Loan Alternatives to Help Build Credit
Building credit is critical for your financial future. You get access to more capital and more attractive interest rates. A high credit score will save you money even if you never borrow funds. Some landlords and utility companies offer favorable terms to consumers with good credit. A personal loan can become more trouble than it’s worth. You can use these alternatives to build your credit score without incurring as much debt.
Secured Credit Card
Credit cards let you use your future money to purchase goods and services in the present. This advantage can lead to debt if you are not responsible, but paying off credit card debt on time will improve your score. Most credit card issuers want to see good credit before giving you an unsecured credit card. However, the same issuers are more flexible if you ask for a secured credit card.
Secured credit cards require a minimum deposit. This minimum deposit acts as your credit limit. You have to continue funding your credit card to spend beyond your limit. Credit card issuers feel more confident giving you a credit card if you fund it before using it for purchases. Many consumers start with secured credit cards to build credit. After raising their credit score, these consumers proceed to apply for an unsecured credit card. You should avoid qualifying for too many credit cards simultaneously since each application will trigger a hard inquiry.
Personal Line of Credit
A personal line of credit is similar to a loan, but you only pay interest if you borrow against the principal. You can tap into a personal line of credit anytime you need it, and you don’t have to reapply after paying off your line of credit the first time. That means no additional waiting times or origination fees. Payments towards your personal line of credit get reported to the major credit bureaus and will improve your score. Obtaining a personal line of credit also increases your credit limit. A higher credit limit will improve your credit utilization ratio, a key metric influencing 30% of your credit score.
Debt Consolidation Loans
Debt consolidation loans reduce stress and lower interest payments. Lower payments are easier to cover, and monthly payments on debt consolidation loans will improve your credit. These loans combine smaller debts into a single entity and help you catch up on existing debt. Some borrowers use personal loans as debt consolidation loans. You should only consolidate debt with higher interest rates than the debt consolidation loan. Credit card debt is a popular candidate for debt consolidation loan coverage.
Credit Builder Loans
Credit builder loans are financial products specifically for people who want to build credit. These loans have small principals that rarely exceed $1,000, along with short terms. Most lenders only let you access the principal after fully paying off the loan. However, some let you access some of the principal right away. You can use this money to cover emergency expenses or keep up with monthly loan payments.
Secured Credit Builder Card
A secured credit builder card allows you to build your credit with every on-time payment. You have to fund your credit card to meet the initial credit limit. It’s possible to grow your credit limit by contributing more funds to the card. You don’t need a credit history to obtain a secured credit builder card.
Frequently Asked Questions
Personal loans appear on your credit. Making payments in a timely fashion will improve your credit score over time.
Personal loans allow you to build credit the moment you make on-time payments. The impact it has on your credit score depends on several factors, such as your current score and what information is on your report. Building credit is a long-term journey that can take several months or years.
Any loan can build your credit score as long as the provider reports your payments to the major credit bureaus. Most financial institutions, credit unions, and online lenders do this. However, paying back cash advances will not improve your score since cash advances are not reported to the major bureaus.
