Personal Loan to Build Credit

Maybe you’re just getting started in the bewildering world of your personal finances, which means your payment history has yet to be written. It’s still a blank slate.

Or maybe you’ve been there/done that world for a while but the visit went badly, meaning you didn’t make the timely payments expected of you in return for credit you’d previously been granted.

In either situation, your credit score needs a boost if you’re going to live happily ever after in the realm of your own dollars and cents.

A personal loan might provide the lift your credit score needs. Or, more accurately, the right kind of personal loan managed properly might provide that lift. We’ll have more to say about those italicized words a little later, but first, let’s make sure we all appreciate the benefits of improving your credit score.

For one, you’ll have an easier time renting an apartment. For another, you’ll get better loan terms on big purchases like a car or home. Among others, your insurance rates will go down and you’ll discover new access to credit cards that feature the top rewards programs.

Bottom line: A good credit score sets you up for a sunnier journey into your financial future.

So, do personal loans build credit? Can they improve your credit score? Yes, but only if you do it right. The plan won’t work for everyone. Let’s examine how a personal loan should fit into your thinking at this particular whistlestop on your monetary travels.

Does Getting a Loan Affect Your Credit Score?

You could, and probably should, be asking something like this right about now: “If the goal is to keep my head above the waters of debt, why would I tie my foot to the concrete block of a commitment to pay back a personal loan?”

Glad you asked. It’s a good question, well-crafted except that you might’ve reached too far for those clunky metaphors about drowning.

Anyway, the answer is found in the italicized words in the second paragraph from the top of this story: the right kind and managed properly. There are several considerations, called FICO score factors, that determine your credit score, and they’re the reasons a personal loan has to be chosen wisely and nurtured carefully if it’s going to build your credit. These factors all play a role in what a personal loan can do for you. Or to you, if you don’t manage it correctly.

Payment History

Your track record for making your payments on time is the single biggest component in why you have the credit score you have. (Yes, the credit bureaus see all and know all about when you pay your bills.) Your payment history accounts for 35% of your total credit score, which can be as low as 300 and as high as 850. Hint: Higher is better.

Make the payments on your personal loan in full and on time, and your credit score rises. Miss a few, or only send a partial amount of what you owe, and it sinks. Keep that in mind as you weigh what your monthly obligation will be for paying back your new personal loan.

Length of Credit History

Did we mention that the three credit bureaus (Equifax, TransUnion and Experian) see all and know all about your credit record? That includes how long you’ve had that record. The longer you’ve been developing a credit history without any major problems (missed payments, defaults, etc.), the better. It sends a signal to the bureaus that you’ve been meeting your financial obligations and so can probably be expected to meet them in the future, too. Hence, your credit score is impacted positively.

That isn’t going to help you much if you’re just now dipping your toes in these waters. You won’t have the kind of history that opens doors to some of the more desirable loan terms and credit cards, for example. But you’ve got to start somewhere, and the credit bureaus recognize that you need credit to get credit. They’ll look kindly on the right personal loan such as a credit-builder loan (more on that to come) as the first chapter in your recorded credit history, assuming you successfully pay it off.

If you’ve already been in the credit game for a while, be aware that the age of your accounts only makes up 15% of your total score.

Credit Mix

Here’s something else the credit bureaus like to see when they’re calculating your score: a variety of types of credit. Adding a personal loan to other kinds of credit such as credit cards, retail accounts, or a mortgage should raise your number … assuming, again, you stay current with your payments on all of them.

Why does it matter to the credit bureaus? They can see how well (or how poorly) you handle your payments and due dates on different kinds of loans and lines of credit. Your credit mix only accounts for 10% of your score, but the bureaus use that information as part of their evaluation of the risk they think you pose when it comes to borrowing more money in the future. So, a new personal loan should help build your credit if it will expand the range of your existing credit commitments.

Recent Credit

We haven’t yet mentioned the middleman between you and the credit bureaus when it comes to the personal loan, you’re thinking about taking out: The institution from which you want to borrow money. Since it’s taking a risk in letting you use its bucks, it has an understandable interest in your trustworthiness. Every time you apply for a loan or any other kind of financing, the lender checks in with the credit bureaus for a report on your score.

In many cases, that check-in takes the form of a hard inquiry into how you’ve been doing with your existing credit. Generally, you have to give permission for a hard inquiry, but the chances you’ll get the loan decrease dramatically if you don’t grant it. When the inquiry has been completed, the lender often leaves notice of its official review in your credit report, where other potential lenders can see it.

Every hard inquiry causes a small, temporary drop in your credit score. If there are several recent hard inquiries on your report from personal loan applications, lenders often suspect you’ve been having cash flow problems and might consider you a risk as a borrower.

Personal Loan Options for Building Credit

We’ve been talking about the importance of choosing the right kind of personal loan, and you’re probably impatient by now to find out what that means. Well, we’re finally ready to tell you. But first: Thanks for plowing through all that other stuff up above. It’s necessary context.

There are two kinds of personal loans that can be effective at bumping up a credit score: debt consolidation loans and credit-building loans. The best personal loan to build credit for you depends in part on where you are with your credit right now.

If you’re just starting down the road to creditworthiness or you need to make up some ground on a credit score you’ve already tanked, you might consider a credit-builder loan.

If you already have an established, but spotty, credit history and your score isn’t where you want or need it to be, then a debt consolidation loan could be the better option.

Debt Consolidation Loan

Take a look at your existing credit accounts. How many are there? How much do you owe on them? If it’s a lot and making all those payments has become a challenge, there’s a good chance your credit score will be suffering soon, if it isn’t already. A debt consolidation loan allows you to pay off all or some of those current accounts with a new loan, so you’re only making one monthly payment. If it’s the right consolidation loan, you can be paying less each month for the one new loan than you were when you totaled up your commitments to the separate accounts.

Here are some of the ways a debt consolidation loan can help build your credit:

• You can reduce the interest rate on your debt and cut more directly into the amount you owe. Both your credit utilization ratio (the percentage of your available credit you’re actually using) and your debt-to-income ratio (the number you get when you divide your monthly debt payments by your gross monthly income) will improve. Your credit utilization ratio is a major factor (it counts for 30% of your score) in your credit score; your debt-to-income ratio isn’t, but lenders look at it when they’re considering your application for more credit.
• A debt consolidation loan can improve your credit mix, which, as we pointed out earlier, accounts for 10% of your credit score.
• It allows you to reduce the number of monthly payments you need to make, minimizing the possibility that your credit score will be negatively impacted by a late or missed payment on one of the accounts you consolidated into the new loan.

It isn’t impossible, but an effective debt consolidation loan with bad credit can be challenging. You’ll likely have to look harder, starting with banks and credit unions. Some online debt consolidation lenders will also take you on as a client, though you should be wary of the interest rates they charge.

Credit-Builder Loan

Most traditional loans put the money in your pocket as soon as the lender approves your application, and then you’re responsible for paying it back in monthly installments. A credit-builder loan turns that sequence around. You make the payments first and get the money later. The lender holds the amount of the loan in a savings account where it can earn interest while you’re paying it off. At the end of the loan’s term, assuming you’ve stayed current with the payments, you get the amount you borrowed and can use it however you see fit.

Credit-builder loans generally aren’t large or long-term; they usually range from $300 to $1,000, with repayment periods of six to 24 months.

Here’s how they can help build credit:

• Because the lender should report your regular payments to the credit bureau, a credit-builder loan allows you to establish a positive payment history.
• Even for beginners in the credit world, it counts as a part of the credit mix the credit bureaus like to see.
• You don’t need a solid credit score to get one of these loans. A credit-builder loan can boost a score for people just starting out as well as for those who are trying to make up for lost credit-score ground.

How to Get a Credit-Builder Loan

There are a number of financial institutions that offer credit-builder loans, and it’s wise to research as many of them as possible to make sure you choose a loan you can manage properly. (Those words again!) Be certain you’ve got the lowest available interest rate and that you understand exactly what the monthly payments will be.

Community banks and local credit unions are good places to begin the search, though be aware that credit unions likely require membership. It’s worth it to check around to see if a local Community Development Financial Institution (CDFI), which is designed to help lower-income communities, offers credit-builder loans.

Online lenders likely will make them available, too, though you’ll want to be careful to make sure they’re licensed in your state and that they aren’t hiding extra costs associated with the loan. And sometimes, a local lending circle of family members and friends features a credit-building plan that might even offer interest-free loans and report your payments to the credit bureaus.

When you’ve gathered enough information from enough different sources, review the terms and conditions so that you’re choosing a loan that best fits your personal financial situation.

Risks of Using a Personal Loan to Build Credit

It’s time now to get to the nitty-gritty about what can go wrong if you don’t heed the warnings – right loan, managed properly – we gave you in the early going. If you aren’t careful about choosing your loan and aren’t diligent about paying it back on time, you won’t build your credit. In fact, you’ll tank it. You’ll be worse off than you were before you started down this road.

That’s why we keep harping on the importance of researching the personal loans that might be available. (Note: Researching a variety of loans is good, but actually applying for a variety of loans isn’t. Those pesky hard inquiries will get attached to your credit report.) It’s the best way to make sure you identify one that fits into your current financial picture. Find a sensible interest rate. Make sure you can handle the size of the monthly payments. Ask, and then ask again, about any fees or penalties that might affect the terms of the loan to which you’re agreeing.

Let’s look at some of the hazards.

Gaining Debt

This probably goes without saying, but you have to pay a personal loan back. That means you’re taking on debt as soon as you sign on the dotted line. In most cases, avoiding debt is the right move for your financial health and well-being, not the other way around. If a new personal loan is for more money than you really need and becomes troublesome for your budget (you do have a budget, right?), then it might end up sending your credit score in the wrong direction.

That said, it’s worth remembering that a debt consolidation loan could help you reduce your debt load by paying off some or all of your existing balances and giving you a single, and lower, monthly payment to make at a better interest rate.

Fees

Your lender is in the business of making money, and sometimes that money comes from more than just the interest rate he or she charges you. Read the fine print of the loan agreement you’re considering and keep asking about fees and penalties. They can cut into the amount you’re borrowing and increase the cost of the loan you’re taking, to the point that the whole darn transaction gets too expensive to make sense as a credit booster.

They can come in a number of sneaky shapes and sizes, including an origination fee, an application fee, a prepayment penalty, a late fee, and a payment processing fee. They’re all over and above the amount you agree to borrow.

Hard Inquiry on Credit Report

Let’s review. The more hard inquiries there are in your credit report, especially over a recent period of time, the more you’ll be considered a risky investment by lenders. If you’ve applied for several different personal loans that all resulted in hard inquiries, your credit score will take a hit. Even the one hard inquiry from a successful personal loan application will make a negative difference for a short period of time.

The drop should only be temporary, but the possibility nonetheless reinforces a lesson about your personal loan decision: Identify the best fit for your finances of interest rates and monthly payments and apply for that loan only. Don’t scatter-shoot your way through numerous applications and hard inquiries.

Missed Payments Can Hurt Your Credit Score

The law says you’ll get at least 30 days of grace after your personal loan payment’s due date before your lender will report you to the credit bureaus for being late. But if you can’t or don’t pay after that, guess what? Yep, it shows up on your credit report and your score can go down by 100 points or more. The longer you’re in arrears, the lower your score gets. The credit bureaus don’t play around with missed payments.

Lenders May Not Report Personal Loans to Credit Bureaus

Here’s another reason to not to jump willy-nilly into the first loan you find. Not every lender is in the habit of reporting your prompt and in-full payments to the proper authorities (the credit bureaus). You’re taking out a personal loan, at least for these purposes, to show the credit bureaus how trustworthy you are so that they’ll raise your score, and you’ll build your personal credit. What would be the point if the credit bureaus never hear about your successful payment history? Make sure those payment reports from your lender to the credit bureaus are a part of the deal.

Alternative Ways to Build Credit

All those risks in the section you just finished reading? They should give you pause. They shouldn’t stop you, necessarily, but they’re the reasons you need to be very careful about using a personal loan to build credit.

And you should know that a personal loan isn’t the only way to build credit. You have other options, many of which don’t carry the peril to your credit score that a mis-chosen or mismanaged personal loan does.

Here are some of the alternatives you might want to consider:

• Get a secured credit card: This comes with a built-in safeguard that works a little like a credit-builder loan. You secure the card up front by depositing a specified amount of money into the account before you start using it. So, if you want a $1,000 credit limit on your card, you give the bank a $1,000 deposit. Basically, the deposit serves as collateral against the line of credit the card provides. From the lender’s perspective, the security deposit makes you less of a risk even if you don’t have a credit history. From your perspective, secured credit cards are an easy way to start building that credit history. But a secured credit card isn’t risk-free. If you miss enough payments and default, you’ll forfeit the collateral and damage your credit score.
• Become an authorized user: If a family member or trusting (and trustworthy) friend is willing, you can piggyback on his or her existing credit card account. You’ll share the accountability for making the payments, and your credit report will show the same account history as the original cardholder. Again, there is a risk, though. If you and your friend or family member don’t make the payments, you both suffer the credit score consequences.
• Co-sign on a loan: Like becoming an authorized user on a credit card, you can co-sign on a personal loan if you have a family member or friend willing to help you when you’re having trouble getting approved for one on your own. The same caveat applies: You’ll damage both co-signers’ credit when you miss payments or default.
• Report alternate payments: When the credit bureaus compile your credit score, they don’t necessarily limit their input strictly to your history with credit cards or loans. They might also factor in how reliable you’ve been at paying your other bills, such as for your rent, your utilities and your phone. It’s worth asking someone in those accounting departments if they’d be willing to notify the three credit bureaus whenever you make timely payments.

Speak to a Credit Counselor

So, what do you think? Is a personal loan to build your credit a smart move for you right now? Can you afford to take the new debt on? Are you willing to live with the risks associated with a personal loan?

Are you comfortable it won’t backfire on you and send your credit score down rather than up? Do any of the alternatives seem like a better way to build your credit?

Tough questions, all. The good news is you don’t have to answer them alone. Expert advice is available from an accredited nonprofit credit counselor who will help you review all your options when you’re looking for the best way to build credit.

If damage to your previous credit is making it difficult to get approved for a new credit card or a loan, or if multiple debts are dragging you deeper into a downward spiral, credit counseling can help you put together a personalized strategy to get on the path to a financially secure future. Counselors might suggest another form of debt relief – debt management plan, debt settlement or bankruptcy – that could be the right solution.

Call a nonprofit credit counseling agency and have information on your income and expenses handy. Counseling can be done over the phone, in person or online. An initial session usually lasts about 40-45 minutes, and if you get it from an accredited nonprofit counselor, the first session is free.