How To Use Personal Loans To Build Credit

Images by Getty Images; Illustration by Austin Courregé/Bankrate

Though they’re a form of debt, personal loans can also serve as a tool to build credit. This is because they can contribute to your payment history and credit mix in addition to lowering your credit utilization ratio. Collectively, these three factors account for 75 percent of your credit score.

But just because they’re a good credit-building tool for some doesn’t mean they’re the right strategy for you. Consider all the moving pieces — including risks — before deciding.

How do personal loans build credit?

There are three main ways a personal loan can benefit your credit:

• Build a positive repayment history: When you take out a loan, most lenders report your payment activity to the three major credit bureaus — Experian, TransUnion and Equifax. On-time payments have a positive impact on your credit, as payment history accounts for 35 percent of your FICO score.
• Add to your credit mix: Having different types of credit accounts in good standing shows lenders that you’re able to manage different debts responsibly. By adding a personal loan to your report, you’re contributing to the diversification of your credit mix, which makes up 10 percent of your score.
• Reduce your credit utilization ratio: If used to consolidate revolving debt, such as credit cards and lines of credit, personal loans can reduce your credit utilization ratio. This accounts for 30 percent of your FICO score and measures how much credit you’ve used relative to your available limit.

Which personal loans can help build credit?

If paid consistently, any personal loan can be a positive addition to your credit report. That said, debt consolidation loans and credit-builder loans are a better option if your main goal is to increase your credit score.

Debt consolidation loans

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. It could also improve your credit mix since credit-scoring models like to see a variety of revolving debt and installment 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 risk paying more in interest accrual over the life of the loan.

Financial institutions — like online lenders, banks and credit unions — can provide debt consolidation loans. To qualify for the best debt consolidation loan rates, you’ll need to have a solid credit score — typically 740 or higher — and have a stable source of income. Some lenders also allow co-borrowers or co-signers, which could help you qualify for a better loan if your credit is less than ideal.

Credit-builder loans

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.

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.

Just like other kinds of personal loans, credit-builder loans are available through some banks, credit unions and online lenders. To apply for these, you typically don’t need to pass a credit check, just provide some personal information. This includes your full name, address, social security number, bank account information and rent or mortgage payment.

Risks of using loans to build credit

Bankrate’s financial freedom survey found that out of all U.S. adults who do not feel financially secure, 26 percent say it’s due to high or revolving debt. Although applying for a personal loan can help you build credit, this also translates to more debt in your portfolio.

Consider these risks before taking on more debt:

• Potentially high rates: If you have a FICO score below 670, you may want to think it over before getting a personal loan to build credit. That’s because bad credit loans tend to come with much higher interest rates and fees compared to other loans, which can make repayment more difficult.
• Initial hard inquiry: Any time you apply for a personal loan, you’ll get what’s known as a hard inquiry on your credit report. Hard inquiries can cause your score to temporarily drop a few points, but it’s generally easy to counter with on-time payments.
• Risk of credit damage: Falling behind on payments and defaulting could cause major harm to your credit file. In the same way that a positive payment history can build your credit, missing payments can cause your score to fall.
• More debt: Depending on your financial situation, taking out a loan can make it more difficult to achieve financial goals, like saving for a home or retirement. Carefully evaluate your situation before signing on the dotted line. Remember, you shouldn’t take out a loan if it is going to cause financial hardship.

Alternatives to personal loans to help build credit

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

• Secured credit card: These cards require you to put down a deposit in a separate account, which then becomes your credit limit. Secured cards can boost your credit through on-time payments. However, if you default on your payment, the lender or issuer can seize your collateral to recoup any losses.
• Joint accounts: Co-signing on a loan or becoming an authorized user on a credit card can help build your credit since both you and the account holder can benefit from a positive payment history. That said, co-signing has more serious implications than being an authorized user. That’s because you’re legally responsible for the loan.
• Report alternate payments: Some services, like Experian Boost, allow you to get credit for paying everyday bills, such as streaming services, monthly subscriptions and utilities, which typically aren’t reported to the credit bureaus. You can also ask your landlord to report rent payments to improve your score.

Bottom line

Personal loans can help you build credit if you use them to consolidate your debt or establish a timely payment history. If you choose to use a personal loan for credit building, remember to consider the risks involved.

If you’d rather avoid taking on additional debt just for the sake of building credit, consider becoming an authorized user on someone’s credit card or reporting your everyday bills. Both options could improve your score without taking any major financial risks.