Credit scores are an everyday factor in our lives, whether or not we’re aware of it. How much you pay on your home mortgage or your auto loan is impacted by your credit rating. How large of a loan you can take out from the bank, and at what interest rate is mostly determined by your credit rating. The better your rating, the more credit available to you and the lower the interest you will have to pay.
Knowing this, it only makes sense that you want to improve your credit rating as much as possible. One of the ways to do this is to use a personal loan to build credit.
Ways to improve your credit score with a personal loan
There are multiple methods for using a small loan to build credit ratings. Some of the more popular and less risky methods are outlined below. With all of these, though, it is essential to exercise good credit practices, like don’t borrow more than you need for your goal. Consider automating payments to ensure that you don’t miss any payments. And don’t borrow what you won’t be able to pay back; this will lead to a downward spiral of bad credit and debt.
One of the more popular and strategic uses of personal loans is to consolidate debt. Imagine that you have three credit cards, each with an outstanding balance on them. You’re making three different payments each month at three different interest rates. What a personal loan does here is allow you to borrow the money needed to pay off all three cards and then pay that loan back with one payment per month, often while saving money in the process. This is just one example of using a personal loan to build credit.
The potential savings to be gained from this method are due to personal loans often having a lower interest rate than credit cards. In the process of this debt consolidation technique, you will improve your credit rating by making these payments and resetting the balance on your cards.
Credit buidling loan
Another technique is the use of credit-builder loans. A credit-builder loan is a loan where you make fixed payments month over month toward the amount of the loan. Once everything is paid, plus interest, you finally receive your funding.
These credit-builder loans can feel counter-intuitive, as you don’t gain access to the borrowed money until after you’ve paid it off, but that is precisely the point of them. At the end of your payments, you will have built credit through your monthly payments, and you will gain access to a savings account with the total amount of the loan in it. At that point, the money is yours without strings attached, completely paid off.
Risks of using personal loans to build credit
While personal loans certainly can be useful for improving your credit rating, there are also some risks that you should be on the lookout for. Before getting a loan to build credit, think carefully through these factors and make sure that taking out a loan is the right choice for you. There are three main risks to be aware of.
Hard inquiry on your credit report
Any time that you apply for a personal loan, what’s known as a ‘hard inquiry’ will be initiated on your credit report. This inquiry will create a temporary drop in your credit score that will usually last for no longer than a few months. While one of these is manageable, it can become very detrimental if you are shopping around for loans and end up with multiple hard inquiries initiated on your credit report.
Any loan that you take out is debt that you take on. While obvious, it still needs stating that you shouldn’t take out a loan if the debt of it is going to push you into financial hardship. Even when using your personal loan to pay off debt and reduce interest rates, it’s vital that you limit any spending behavior that would add more debt while you’re paying off your personal loan. A downward spiral of debt is not a good place to be.
Lastly, there’s more to pay on a personal loan than just the borrowed money and interest. There are fees associated with nearly every loan available. While a minor cost compared to the loan itself, you don’t want to be blindsided by these fees. Make sure you know what fees are associated with any loan before you consider signing off on it.
Alternative ways to build credit and the risks of each
Secured credit card
A secured credit card is a special kind of credit card that uses money you’ve set aside in a specific account to serve as collateral against the line of credit that you have on the secured card. According to Capital One, a secured credit card differs from a traditional credit card mostly in how your credit amount is determined. With a conventional credit card, it is determined by your credit history, but with a secured card it is mostly based upon the size of the security deposit you make when applying for the card. This can be very useful when you are trying to build credit from bad credit or no credit.
Just like with any debt, using this secured credit card and not making at least the minimum monthly payments will hurt your credit score and cost you money. If you plan to use a secured credit card, make sure that you don’t charge more to it than you will be able to pay off.
Cosigning on a loan can help build your credit. This works because when you cosign, you share complete responsibility for the loan. If you know that the person you are cosigning for can and will make their monthly payments, then this can be a viable way to build your credit rating.
Keep in mind that if the person you cosign for misses any payments or defaults on the loan, then not only will it hurt your credit rating, but you will be legally responsible for making up the lost payments.
The bottom line
Credit scores are important and complicated, but you aren’t powerless. When used properly, personal loans build credit. There are multiple ways to establish and build your credit score, ranging from using personal loans to build credit, to debt consolidation, to cosigning on an auto loan. Whatever option you choose, though, remember to be conscientious of the risks involved and not to get yourself into a situation where you owe more money than you can pay.