Many people who need to take out a personal loan to cover expenses often worry that doing so could damage their credit score. In fact, it’s the opposite–taking out a personal loan can actually help you build credit. And that’s important. Because credit helps you whenever you need money. For example, if you need a loan to buy a car or you need a credit card to purchase items that you can pay for later, having credit allows you to do that. That’s because the main two types of credit are installment loans, which you pay back in small amounts over a period of time, and revolving credit, which is a line of credit you can keep using even after you pay it off–a credit card, for example.
The more you improve your credit score, the better off you’ll be whenever you need to take out a loan or borrow money from a lender. Here’s a look at what we’ll cover when discussing personal loans:
- What is a personal loan?
- Can taking out a loan help build credit?
- Risks to opening a personal loan to build credit
- Alternatives to building credit
What is a personal loan?
A personal loan is money borrowed to pay for personal expenses. Unlike car loans, mortgage loans, or student loans, which limit what a loan can be used for, personal loans allow borrowers to use their money however they would like. Personal loans, which can be taken from an online lender, bank, or credit union, are expected to be repaid in small portions over time with interest added on. These loans are often unsecured, meaning borrowers are not required to offer collateral (such as a house or a car) to secure their loan.
You can learn more about personal loans here.
Can taking out a loan help build credit?
Absolutely. Taking out a personal loan can help build your credit score–but only if you repay it on time and in full, which can positively impact your credit. On the other hand, if you are late with payments or fail to repay the loan at all, your credit score will suffer. Some of the benefits of taking out a personal loan include:
Increases credit history
Investopedia defines credit history as a measure of your ability to repay debts and your demonstrated responsibility in repaying them. This is then recorded in your credit report, which details the number and types of your credit accounts, how long each account has been open, the amounts you owe, the amount of available credit used, whether your bills are paid on time, and the number of recent credit inquiries. When you take out a personal loan, you begin to build a history of credit. If you have a long credit history, you come across as a borrower that lenders and credit bureaus can trust. This can help you get approved for future loans.
Improves payment history
When it comes to credit, you want to build trust. When a lender trusts a borrower to repay the money they’re providing, the personal loan works and the borrower’s credit grows more and more solid. As long as borrowers repay their loan’s monthly payments on time, they’ll build that trust with the lender, which will lead to a better credit and payment history.
Reduces credit utilization
Credit utilization ratio is the money you owe on your credit cards, divided by your total credit card limit. So, if you have a $1,000 balance on a credit card with a $2,000 credit limit, you have used half your available credit–that means your credit utilization is 50 percent. This ratio is something that credit reporting agencies can use to determine how well you’re controlling your finances. The best way to reduce your credit utilization ratio? Pay off your debts and balances every month. You can use a personal loan to accomplish this by paying off your debts with the money you receive from the loan–and then by paying off the personal loan in a timely manner.
Adds to your credit mix
A credit mix is the types of different credit accounts you have, such as credit cards, loans, mortgages, and others. Credit mix is often considered when determining your credit score (most FICO scores will use credit mix to account for about 10% of your overall credit score), so it’s good to have a mix of credit. However…just because credit mix can help your FICO credit score, it’s not recommended that you apply for more loans or credits just to improve this part of your credit score. Doing this can negatively affect other parts of your credit score that account for more. That means your credit score can actually suffer by opening loans and credit cards you don’t need. Only take out a loan or open a credit card if you need to as accumulating credit card debt will result in a bad credit score.
Risks to using a personal loan to build credit
As we mentioned, one risk to opening a personal loan to build good credit is that doing so unnecessarily can actually damage your credit score. There are other risks to consider as well, including:
Hard inquiry when applying for a loan
When you apply for a loan, a process goes on behind the scenes. The lender from which you’re requesting a loan will ask to review your credit report as part of the application process. When this happens, it may be recorded on your credit report as a “hard inquiry”, which is basically a timeline of when you have applied for new credit. A hard inquiry will usually impact your credit score, sometimes for a year (it stays on your credit report for up to two years, however).
Adding to debt
Sometimes personal loans are needed to pay off certain debts or expenses. That part is great. But this means you now have another debt to pay off. Even if you’re using a personal loan to pay off another debt, you still also have to pay off the personal loan on time.
Nearly any loan you take out–whether personal, mortgage, auto, student–will have extra fees associated. This is common, but not all fees are the same. Be sure to read your loan terms closely to determine exactly how much in fees you’ll be paying on the loan. If necessary, compare lenders, because some offer lower fees that may be more affordable.
The possibility of failure to make payments or defaulting on the loan
Taking out another loan also raises the possibility that you won’t make on-time payments or will default on the loan altogether. Unforeseen circumstances (such as loss of job, unexpected medical expenses, etc.) do happen, unfortunately, and having another loan can be a risk if these situations occur. Of course, this is a risk everyone takes with any type of loan or line of credit. But your credit score can be negatively impacted if you make late payments or default on the loan.
Alternatives to building credit
Taking out a personal loan is often necessary–taking out a personal loan for the sole purpose of building credit, however, is not and should be avoided. After all, there are other ways to build credit, each with their own benefits and risks.
Report alternative payments
Many people are unaware that their phone, cable, and internet service providers are able to report your payments to credit bureaus–all you have to do is ask! Doing so can help establish and build good credit without the risks associated with taking out a loan or opening a credit card–as long as you’re making these provider payments on time, of course.
By authorizing another user on a credit card or having a co-signer on a loan, you’re now splitting the responsibility of payment between you and someone else (generally a family member). This means that only one person is required to make the monthly payments–and as long as that is done on time and regularly, both people benefit. However, the lender or credit card company hold both people accountable if payments are not made on time and regularly.
Did you know that there are two types of credit cards? Secured and unsecured. A secured credit card requires a cash security deposit when you open the account, which reduces the risk to the credit card issuer. How? If you fail to pay your bill, the credit card issuer will simply take the money from your deposit to cover the payment. Secured credit cards are usually good options for those with bad or no credit. By using a secured credit card responsibly (making payments on time), you can improve your credit to the point where you may be able to qualify for an unsecured credit card. Keep in mind–secured credit cards often come with higher interest rates, so it’s best to pay off as much as you can each month to avoid interest charges piling up. With that in mind, credit unions tend to offer lower interest rates than bank-issued cards, but are much harder to gain eligibility as a member.
An unsecured credit card does not require a cash deposit upon opening. Because they’re a larger risk to the card issuer, however, applicants must have average or above credit to receive an unsecured card. If you do qualify for an unsecured credit card but don’t have great credit, be on the lookout for very high fees. This article by NerdWallet provides a great breakdown of secured credit cards vs. unsecured credit cards.
Personal loans can help build credit
As you can see, there are many ways to help you build your credit score. Taking out a personal loan is one of them, because, by paying your monthly loan payments on time, you establish a credit history and a payment history while proving to lenders and credit bureaus that you’re a trustworthy borrower.
Sun Loan is here whenever you need a personal installment loan. Throughout our 30-year history, our friendly and professional loan specialists have been helping people with personal installment loans and ensuring they have an affordable payment plan that fits their needs. Other lenders? They’re only interested in credit scores. Our team is ready to assist you with financial decisions by providing a monthly budgeting overview and helping you understand your credit score so you’re able to successfully make on-time payments, establish your credit history, and build your credit score. Stop by one of our local branches, give us a call at (800) SUN-LOAN, or apply online.