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A low credit score creates all sorts of problems — from the inability to qualify for an apartment to disqualifying you from loan options like an auto loan or a mortgage. But it can take time and strategy to improve your credit rating if you have dings on your credit report. One way to work on improving your score is by taking out a personal loan.
A few different types of personal loans can help you improve your score. Consider all the options to figure out which option works best for you. If your score is so low it disqualifies you from personal loan options, there are other ways you can work to bring your score up.
Why using a personal loan can help build credit
You need to understand how credit scoring works to improve your credit score. Credit scores are provided by the three major credit scoring bureaus — Equifax, Experian and TransUnion. Banks, lending institutions and other authorities may check your credit history to determine if you are a reliable person to lend money to or lease an apartment.
If your credit score is low, you are less likely to be deemed reliable, which can shut you out of opportunities for loans or certain types of credit cards.
Credit bureaus look at six factors to determine your score — payment history, amounts owed, length of credit history, credit mix, hard inquiries and new credit. Taking out a personal loan and making consistent, on-time payments contribute to your credit history and score and can give you positive history that contributes to a higher score. Payment history is valued at 35% of the equation for your score, so simply positively adding to your history can bring your score up over time.
Ways to build your credit score with a personal loan
You can use a personal loan to build your credit rating in several ways. The most popular options are generally debt consolidation loans and credit-builder loans.
Debt consolidation loan
As the name implies, these loans are personal loans used to consolidate debt.
Imagine that you have three credit cards, each with an outstanding balance. You’re making three payments each month at three interest rates. A debt consolidation loan allows you to borrow the money needed to pay off all three cards. You’ll also pay that loan back with one payment per month, often while saving money due to lower interest rates.
This can help your credit in a few ways. For one, if you pay off the balances of your credit cards, you’ll lower your credit utilization ratio — a determiner in your credit score. You may also improve your credit mix since credit-scoring models like to see a variety of revolving debt, like credit cards, and installment loans, like personal loans.
Who this is best for: Debt consolidation loans are ideal for individuals who want to consolidate the balances on their high-interest credit cards into a loan product with a more competitive rate to save money and streamline the repayment process.
A credit-builder loan is a loan product that requires you to make fixed monthly payments over a set period. Unlike traditional personal loans, you won’t have access to the funds until the loan is paid in full with interest.
Once the funds are released to you, they are yours to use however you see fit. Some borrowers choose to increase their emergency fund. Others use the funds to pay down small debts or meet other short-term financial goals.
These credit-builder loans can feel counterintuitive, as you don’t gain access to the borrowed money until after you’ve paid it off. Still, you’ll establish a history of timely payments, which the lender then reports to the credit bureaus. At that point, the money is yours without strings attached, completely paid off. It’s like putting money into a savings account but with the benefit of a credit boost.
Keep in mind that a credit-builder loan isn’t right for everyone. You may have to pay fees to open the loan, and you’ll have to factor in any interest to your monthly pay.
Who this is best for: Credit-builder loans are best for individuals with bad credit or no credit history who want to save money while building credit.
Risks of using personal loans to build credit
While personal loans can be useful for improving your credit rating, there are also some risks. Before getting a loan to build credit, think carefully through these risk factors and make sure that taking out a loan is the right choice for you.
Hard inquiry on your credit report
Any time you apply for a personal loan, you’ll get what’s known as a “hard inquiry” on your credit report. Your credit score could drop, but the impact generally won’t last for longer than a few months. While one of these is manageable, it can become detrimental if you shop around for loans and end up with multiple hard inquiries on your credit report.
Any loan that you take out is debt that you take on. Remember, you shouldn’t take out a loan if the debt is going to cause financial hardship. Even when using your personal loan to pay off debt and reduce interest rates, you must limit any spending behavior that would add more debt while you’re paying off your loan.
There’s more to pay on a personal loan than just the amount you borrowed interest. Fees are associated with nearly every loan available. While they’re a minor cost compared to the loan, you don’t want to be blindsided by these fees. Read the fine print to know what fees are associated with any loan before signing on the dotted line.
Alternative ways to build credit
A personal loan is not the only way to improve your credit score. Consider the benefits and risks of alternatives, like secured credit cards and joint accounts.
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. A secured card’s credit limit is mostly based upon the size of the security deposit you make when applying for the card. Because you could lose your collateral if you miss payments, lenders are more likely to extend this type of credit card to people with bad credit or no credit. Making regular payments, however, could boost your score.
Co-signing on a loan or becoming an authorized user on a credit card can help build your credit because when you co-sign, you share complete responsibility for the loan. If you and the other account holder make monthly payments, you can both benefit from the credit benefits.
Keep in mind that if the person you co-sign 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.
Reported alternate payments
Some service providers may be willing to report account activity to the credit bureaus upon request. Consider reaching out to your cell phone, utility and cable providers and asking if they’ll report payments to the three primary credit reporting agencies — Experian, TransUnion and Equifax — on your behalf. You can also ask your landlord to report rent payments.
Personal loans can help you build credit if you use them to consolidate debt or establish a timely payment history. If you choose to use a personal loan for credit building, remember to be conscientious of the risks involved and compare quotes from multiple lenders to ensure you’re getting the cheapest possible loan for your situation.
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