How To Use Personal Loans To Build Credit

Images by Getty Images; Illustration by Austin Courregé/Bankrate

Although they’re a form of debt, personal loans can also serve as a tool to build credit. By contributing to your payment history and credit mix, personal loans could increase your credit score. Plus, using the loan to pay off credit card debt can also lower your credit utilization ratio. Collectively, these three factors account for 75 percent of your 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 to use a personal loan to build your credit.

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 can manage various 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 reports. 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. Getting a debt consolidation loan 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. If you pay off your credit card balances, 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 what you paid on your previous debts. Otherwise, you risk paying more in interest accrual over the life of the loan.

Many financial institutions provide debt consolidation loans, including online lenders, banks and credit unions. 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 cosigners, which could help you qualify for a better loan if your credit is less than ideal.

Credit-builder loans

Unlike traditional personal loans that provide funding upfront, a credit-builder loan requires you to make fixed monthly payments over a set period before you receive the funds. Once the loan is paid in full, with interest, you’ll receive the funds — and you’ll have built a history of on-time payments.

Once the funds are released to you, they are yours to use however you see fit. Some borrowers choose to begin (or grow) 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, since you don’t gain access to the borrowed money until after you’ve paid it off. However, the primary goal of these loans is to establish a positive payment history that builds your credit score.

A credit-builder loan isn’t right for everyone, especially if you need funds quickly — most credit-builder loans are six to 24 months, and you won’t receive the money until the end of the term. Plus, you may have to pay fees to open the loan, eating into the loan proceeds.

Like other personal loans, credit-builder loans are available through some banks, credit unions and online lenders. To apply, 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 amount.

Risks of using loans to build credit

Although applying for a personal loan can help you build credit, this also translates to more debt in your portfolio. Consider the following risks before taking on more debt:

• Potentially high rates: If you have a FICO score below 670, a personal loan may have more drawbacks than benefits. 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: When you apply for a personal loan (or nearly any form of credit), you’ll get what’s known as a hard inquiry on your credit report. Hard inquiries can cause your score to drop by a few points, but the effect is temporary and it’s generally easy to counter with on-time payments.
• Risk of credit damage: Falling behind on payments and defaulting on the loan could cause significant harm to your credit file. Just as a positive payment history can build your credit, missing payments can cause your score to fall. Missed payments can impact your credit score for up to seven years.
• More debt: Depending on your financial situation, taking out a loan (and increasing the amount of debt you owe) can make it more difficult to achieve your 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 will 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 acts as your credit limit. Secured cards can boost your credit through on-time payments. However, if you fail to repay the balance as agreed, the lender or issuer can seize your deposit to recoup its losses, and your credit score will sustain damage.
• Joint accounts: Cosigning a loan or becoming an authorized user on a credit card can help build your credit, since both you and the account holder will benefit from a positive payment history. That said, cosigning has more serious implications than being an authorized user because you’re legally responsible for repayment of the loan if the primary borrower falls behind.
• 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 your rent payments to improve your score.

Bottom line

Personal loans can help you build credit if you use them to consolidate debt or establish a positive 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 via a third-party service like Experian Boost. Both options could improve your score without incurring any major financial risks.