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Taking out a personal loan can help you build credit, if you do a good job paying off the loan. Making monthly payments on time can boost your credit score.
But if you miss payments or pay late, these negative marks can stay on your credit report for years and can make it difficult to qualify for other types of financing, like a car or home loan.
How to use a personal loan to build credit
If you find yourself in neck-deep credit card debt, you might want to consider a personal loan for debt consolidation. This type of loan consolidates your current debt into one loan with one monthly payment, preferably at a lower interest rate and with better terms.
Personal loan interest rates are typically lower than most credit cards, and you’ll have a predictable payment each month. When you apply, your credit score may be temporarily affected, but if you make all your payments on time, a debt consolidation loan can help you build your credit score.
Factors that affect your credit score
When reviewing your personal loan application, lenders look at your credit score. But that’s not the only thing they consider. They might also look at your employment history, debt-to-income ratio, and whether you have a co-signer or collateral.
The three major credit bureaus use these five factors to determine your credit score:
- Payment history – Your payment history has the most weight when determining your credit score. If you regularly make on-time payments on your personal loan, your credit score will likely improve over time. But if you make late payments or miss payments, it can hurt your credit and stay on your reports for up to seven years.
- Amounts due — When deciding whether to give you a loan, lenders look at how many of your accounts have balances and how much you owe on each. So, paying off or repaying a personal loan can have favorable results on your credit score.
- Length of credit history — Credit history takes into account any new accounts, the age of your oldest accounts, and the average age of all your accounts. When you repay a personal loan, it can stay on your credit report for up to 10 years. During this time, it can continue to help you improve your overall score.
- Composition of credit — Having a combination of different types of credit – credit cards and loans – can boost your credit score. If you have credit cards and take out a personal loan, and manage each one well, you can improve your credit score over time.
- New credit — Take out a personal loan can reduce the age of your accounts, but can also increase your credit score by increasing your available credit.
Potential Drawbacks of Using a Personal Loan to Build Credit
With all the advantages of use a personal loan to build credit, you will also need to consider the potential risks:
- Monthly payments – Depending on the rate and terms of the personal loan, you could find yourself going over budget just to make your monthly payments. If this happens and you fail to repay your loan, your credit will suffer. Before agreeing to a personal loan, make sure that the monthly payment corresponds to your budget.
- High interest rates — For people with good credit, interest rates on personal loans can be much lower than many credit cards. But if you have bad credit or a poor credit history, you might get higher interest rates, which means you’ll pay more interest over the life of the loan.
- Fees and Penalties — Some personal loans come with origination or processing fees, ranging from 1% to 8% of the loan amount, depending on your credit score. Lenders may also charge prepayment penalties for prepaying your loan, so it’s best to review the terms of your personal loan beforehand.
- May increase your indebtedness — A personal loan can help pay off or pay off high interest debt. But if you start racking up more credit card debt as soon as you pay it off, it will increase your debt load and defeat the purpose of getting a personal loan.
Personal loan alternatives to build credit
If you want to build credit but a personal loan isn’t right for you, consider these alternatives.
Credit builder loan
A credit enhancement loan is designed for people with no credit or low credit. A traditional personal loan lets you borrow money up front and pay it back over time. But with a credit loan, the lender will place the loan amount — usually $300 to $1,000 — in a locked escrow account.
You’ll make installment payments, usually over six to 24 months, into a dedicated savings account. Your payments will appear on your credit reports, which can help create credit overtime. And at the end of the loan term, you’ll get the amount back from your savings account, less interest and fees.
Personal line of credit
Personal lines of credit are unsecured revolving accounts of credit. Similar to a credit card, you withdraw funds as needed up to a certain limit. As you withdraw money, your available balance decreases. As you repay the borrowed amount, your available balance is restored.
A downside to personal lines of credit is the potential for a higher interest rate on the amount you borrow than on some credit cards or personal loans. Additionally, some accounts charge overdrafts and annual fees, and there is always a risk of overspending.
Home equity loan or line of credit
If you have accumulated equity in your home, a home equity loan or line of credit may be a good alternative to a personal loan. These loans are secured by your home, so you can often get a lower APR than a personal loan. Moreover, you can use the loan for almost anything. But keep in mind that because your home is being used as collateral, if you can’t repay the loan, you risk foreclosure.
0% intro APR credit card or secured credit card
Although many credit cards come with relatively high interest rates, they can be a good option for building credit if you can find a card with an introductory offer of 0% APR for a certain period. As long as you pay off your credit card balance before the end of the promotional period, you will not pay any interest on the amount. Just make sure you’re able to pay the balance in full before the promotion ends or you’ll start earning interest at the card’s regular rate.
If you have bad credit, it can be difficult to qualify for a 0% APR card. Instead of, you may qualify for a secured credit card which helps you build credit over time. If your credit improves, you may be able to switch to an unsecured card.
Why having good credit is important
If you’ve ever applied for a car loan, rented an apartment, or asked to lower your credit card interest rate, you understand why having good credit is so important. Along with lower interest rates and better terms, good credit is essential to your financial future.
If you need a loan to start a new business, don’t want to pay a large down payment when activating utilities, or want to pay lower insurance rates on a car insurance policy, a good credit score can create opportunities. Remember that building a good credit rating doesn’t happen overnight. It takes time and commitment.