Can personal loans build credit?

Personal loans are flexible installment loans that you can use for many different purposes. When your loan is approved, you’re given the amount of your loan in one payment. You then pay back the loan usually in monthly installments which include the principal amount and any fees on the loan. They’re popular among people looking to do things like consolidate debt or fund home improvements.

Used properly, a personal loan can also help improve your credit score. We’ll cover the basics of how these loans can benefit your credit and tips on how to use them.

Benefits of personal loans to build credit

Any time you get a new loan, it will have an impact on your credit. If you use your personal loan responsibly, it can help give your credit a boost by improving your credit mix, credit utilization ratio, and history of on-time payments.

Improving credit mix

A small portion of your credit score, accounting for about 10% of it, is your credit mix. This refers to the mixture of different types of debts you have. The idea is that someone who has different types of loans, such as an auto loan, credit card, personal loan, and student loan, will have more experience with debt and be better at handling it than someone who only has one or two types of debts.

Adding a personal loan to your credit mix can give your score a small boost.

Lowering credit utilization ratio

Your credit utilization ratio also plays a big role in your credit score. It measures your total debt compared to your total credit limits across all of your revolving debt. The lower your utilization ratio, the better.

Consider this example:

You have two credit cards with a balance of $4,000 and a total credit limit of $8,000, and a home equity line of credit with a limit of $60,000 and a balance of $25,000.

You have a total debt of $29,000 compared to a total credit limit of $68,000, giving you a credit utilization ratio of $29,000 / $68,000 = 42.6%.

You decide to take out a personal loan to consolidate your credit card debt. Because credit utilization ratio only looks at revolving credit, your utilization ratio becomes $25,000 / $68,000 = 36.7%.

Establishing a positive payment history

The most important factor influencing your credit score is your payment history. This is the record of the number of times you’ve made on-time payments and the number of times you’ve been late or missed a payment entirely.

Generally speaking, if you get a personal loan and are careful to make every payment on time, it may help you build your payment history and can improve your score.

Effective strategies for using a personal loan to build credit

If you want to use a personal loan to boost your credit score, you need to make sure you use the loan responsibly and have a plan for making sure the loan will improve your long-term financial health.

Understand credit health and debt-to-income ratio

When you apply for any type of loan, including personal loans, most lenders will have specific requirements for the credit score and debt-to-income (DTI) ratio needed to qualify. For example, many lenders prefer applicants who have a DTI ratio of 36% or less.

Before you apply for a loan, you should check your credit to see if you can do anything to boost your score so you can get a better deal.

By law, you’re entitled to one free copy of your credit report from each of the three major bureaus per year, so you can check your credit before applying.

Shop around for the best loan rate

When applying for a personal loan, you should try to get prequalified with multiple lenders. Prequalification involves a soft pull on your credit, so it won’t affect your score. However, it gives lenders enough info to determine if you’re eligible for a loan, how much you can borrow, and the rate and fees you’ll pay.

You can then look at offers from multiple lenders and try to choose the cheapest one. Keep in mind that many personal loans involve an origination fee, so look at more than just the interest rate of the loan and be careful to check for hidden fees like application fees or early repayment fees.

Set up automatic payments

After you get your loan, you can set up automatic payments with the lender or form your bank. This will ensure that all of your payments are made on time, letting you avoid the potential of missed payments, which may lead to late fees and damage your credit score.

Potential risks of using personal loans to build credit

If you want a personal loan to improve your credit, you need to be sure that you will use it responsibly. In some cases, a personal loan could damage your score.

Understanding the risks of personal loans will help you avoid those scenarios.

Inquiry-related credit score drop

Whenever you apply for a loan, the lender will ask one or more credit bureaus for your credit report. This shows up as a hard pull on your credit and drops it by a few points. If you have a score that is fair rather than good or excellent, those few points can make a big difference.

Increased debt risk

Any time you take on a new loan, you’re accepting the financial burden of debt. Even if you use the loan well, such as to consolidate credit card debt, you need to be ready to handle the monthly payments, even if you face an unexpected financial emergency.

Make sure you have a plan for how you’ll handle payments and look at the big picture financially before you apply.

Consequences of late payments

Payment history is the biggest factor in determining your credit score, and one late or missed payment can cause a huge drop in your credit. With a personal loan, you need to make sure you’re ready to make every payment on time to avoid damaging your credit or paying hefty late fees.

Alternatives to personal loans

Personal loans are one option for people looking to boost their credit, but there are other options out there. If a personal loan isn’t right for you, consider these alternatives.

Credit-builder loans

Credit-builder loans are unique loans designed to help people build or rebuild their credit, even if they have no credit history or a damaged score. In effect, they work like forced savings plans. You receive no money up front. Instead, the lender puts the money into a certificate of deposit on your behalf, and you make monthly payments for a set period, such as a year or two.

At the end of the period, the money in the CD is released to you. If you make timely payments, that gets reported to credit bureaus, and your score can improve, but if you make late payments, it can damage your credit.

These loans also come at a cost. You may get a $1,000 loan and receive $1,000 at the end of its term, but have paid $1,150 in total when all interest and possible administrative costs are included. If you have other options for building credit without paying interest, such as a credit card that you pay in full each month, you may want to pursue those alternatives.

Secured loans

A secured loan is a type of loan where you offer something of value to the lender to help provide security for the loan. This item of value is called collateral.

Mortgages and auto loans are two types of secured loans. The collateral helps keep the risk to the lender low, making these loans easier to qualify for and keeping rates low.

There are also other types of secured loans, including secured personal loans. Collateral can be things like a CD, savings account balance, jewelry, or anything else of value. However, if you miss payments, the lender gets to keep the collateral.

Because these loans are easier to get, you can often qualify even if you have poor credit. Payment activity on secured loans is reported to credit bureaus, so if you handle a secured loan well, it can help you boost your credit score.

The bottom line: Personal loans can help build credit when they’re used responsibly

Used properly, personal loans can be a useful financial tool and can help you do things like consolidate high-interest credit card debt at a lower cost. They can also help you improve your credit score over the long run. The best way to build your credit is to make sure you always make your loan payments on time.

If you’re ready to apply for a personal loan, you can reach out to see what you may qualify for with Rocket Loans℠ today.