Credit scores are an everyday factor in our lives, whether or not we’re aware of it. The better your credit rating, the more credit available to you and the less interest you will have to pay. If you have poor credit, you’ll have a harder time accessing affordable credit.
One way to improve your credit score is to take out a personal loan, since a personal loan could help you pay off debt or establish a good payment history. Here’s how.
Ways to build your credit score with a personal loan
There are multiple methods for using a small loan to build your credit rating. Two of the most popular types of personal loans to improve your credit score are debt consolidation loans and credit-building loans.
Debt consolidation loan
One of the more popular and strategic uses of personal loans is using them to consolidate debt. Imagine that you have three credit cards, each with an outstanding balance. 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 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 key 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.
A credit-builder loan is a loan where you make fixed payments month over month toward the amount of the loan without receiving money in return. Once everything is paid, plus interest, you finally receive your funding.
These credit-builder loans can feel counterintuitive, as you don’t gain access to the borrowed money until after you’ve paid it off, but the real benefit is that you 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 added 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 the amount you pay each month.
Risks of using personal loans to build credit
While personal loans 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 you apply for a personal loan, you’ll initiate what’s known as a “hard inquiry” 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 detrimental if you are shopping 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. It bears remembering 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.
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 they’re a minor cost compared to the loan itself, you don’t want to be blindsided by these fees. Make sure that you know what fees are associated with any loan before signing off on it.
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 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 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.
The bottom line
Personal loans can help you build credit if you use them to consolidate debt or establish a timely payment history. If you do 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 that you’re getting the cheapest possible loan for your situation.