How to improve your credit score with a personal loan

When paid off consistently, personal loans can increase and maintain your credit score through building a positive repayment history and diversifying your credit mix.

While this may be helpful for some, keep in mind that it’s not the best option for everyone. Those with a stable, steady and predictable income and a decent credit score are among those most likely to benefit from this credit building method.

Why using a personal loan can help build credit

Your credit score is one of the most important indicators of financial wellbeing. Lenders and banks often value credit over factors like job history or education, because it serves as a risk indicator. The lower your credit score, the less likely you are to get approved for a loan or qualify for a competitive rate.

Your payment history makes up the largest percentage of your FICO credit score — a whole 35 percent. That being said, making the monthly payments on time and in full is a sure-fire way to see your score rise 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. Let’s say you have three credit cards, each with an outstanding balance and relatively high interest rates. Consolidating this debt will allow you to borrow the money you need to pay off all three cards under a new loan with one fixed monthly payment.

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 — how much of your available revolving credit you’re using. It could 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.

However, consolidating your debt only makes sense if you’re offered a lower interest rate on your new loan than your previous debts. Otherwise, you’ll end up paying more in interest accrual over the life of the loan.

Who this is best for: Debt consolidation loans are ideal for individuals who qualify for a better interest rate and want to consolidate the balances on their high-interest credit cards to streamline the repayment process.

Credit-builder loan

A credit-builder loan 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.

For some, credit-builder loans can feel counterintuitive, as you don’t gain access to the borrowed money until after you’ve paid it off. However, you’ll establish a history of timely payments, which will increase your score over time.

Keep in mind that a credit-builder loan isn’t right for everyone, especially if you need the funds prior to paying down the balance. Plus, you may have to pay fees to open the loan and depending on your credit, the interest rate you’re offered could eat into the overall value of the loan

Who this is best for: Credit-builder loans are best for individuals with bad credit or no credit history who don’t need immediate access to the funds.

Risks of using personal loans to build credit

Before getting a personal loan to build credit, think carefully through these risk factors to make an informed decision that will benefit you both now and in the future.

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. Hard inquiries will cause your score to drop a few points, but it’s generally easy to rebuild your score with a good repayment history.

While one inquiry at a time is manageable and even expected by lenders, multiple inquiries in a short amount of time will decrease your score significantly and may be interpreted by lenders as a risk factor.

Gaining debt

Any loan that you take out is more 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 a personal loan to help pay off debt and reduce your interest rate.

Associated fees

Depending on the lender, it’s likely that any loan you apply for will charge at least one fee. While they can seem like minor costs compared to the overall balance, multiple fees can add up and eat into the overall value of your loan.

Read the fine print in the terms and conditions to know what fees are associated with any loan before signing on the dotted line. If the lender you’re looking at charges multiple fees, it may be best to look elsewhere. Some companies boast that they charge very few fees, and a handful of lenders don’t charge any at all.

Alternative ways to build credit

If a personal loan isn’t the best way for you to build credit, there are alternative methods that — when used responsibly — can help boost your score over time.

Secured credit card

A secured credit card uses money you’ve set aside in a specific account to serve as collateral against the card’s line of credit. Lenders are generally more lenient with secured cards and are more likely to serve borrowers with thin or no credit history as they’re taking on less risk due to the collateral.

A secured card’s credit limit is mostly based upon the size of the security deposit you make. This means you will likely have access to less credit than you might with a traditional card. However, a secured card can still be a great way to boost your score given you make the payments on schedule.

A major drawback of a secured card, and any product that requires collateral, is if you default on the balance, then your collateral can legally be seized to satisfy the missing payments. Before committing to using the card, make sure any resulting monthly payment fits comfortably into your future financial plans.

Joint account

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 the monthly payments on time and in full, you can both benefit from the credit benefits.

But if the person you co-sign for misses any payments or defaults on the loan, the consequence will be two fold. 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.

Bottom line

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.