Can taking out a personal loan improve my credit score? Personal loans can be great tools to help people bridge a financial gap, consolidate debt, or make a significant purchase. They can also be a good way to build or rebuild your credit, but like any other loan, they come with risks and can help or hurt your credit scores, depending on how you manage the loan.
Highlights:
- Personal loans can help build credit if you repay them on time
- Failing to repay or being late can damage the borrower’s credit further
- Borrowers with spotty credit may have a harder time qualifying for a personal loan
- Personal loan alternatives include balance transfer credit cards, secured credit cards, and installment loans of various types
Can Taking Out a Personal Loan Improve My Credit Score?
Before going too far, it’s important to note that even the best personal loans are still debt and should be taken carefully with the knowledge that failing to make regular payments can have a negative impact and cause your credit scores to drop substantially. That said, taking a personal loan and making payments on time will ultimately be a positive thing for your credit score.
Lenders report on-time payments to the major credit bureaus, which is a great way to build or rebuild credit. However, because many personal loans are unsecured, lenders often require stronger credit scores to qualify, which may put them out of reach for people needing to boost their scores.
It’s also a good idea to note that the loan application process involves a hard credit inquiry or credit check, which will temporarily negatively affect your credit score. Having a small number of inquiries is no big deal, as they happen any time you buy a car or apply for a credit card, but multiple inquiries can be a red flag, lowering your score.
What is a Credit Score?
FICO, or the Fair Isaac Corporation, is the credit scoring model used in the United States. Individuals receive a three-digit FICO score that is used by lenders to determine a borrower’s creditworthiness and risk. Another common credit score you may see is your VantageScore, which is based primarily on similar scoring criteria. The scores are calculated based on five primary factors: payment history, length of credit history, new credit accounts, types of credit, and credit utilization ratio or your current outstanding amount of borrowed money.
Lenders use this information to determine whether to issue a loan, but they also use the borrower’s credit score to set interest rates and terms for a loan or financial product. Some may qualify for a personal loan but be required to pay more in interest, while others are approved with more reasonable rates due to having higher credit scores.
What is a Personal Loan?
Personal loans, like the ones offered by Credible and other high-quality personal loan providers, are a type of loan that individual borrowers can receive for a number of reasons, including debt consolidation, paying medical debts, home improvements, and more. They are often unsecured, which means the bank does not require the borrower to offer collateral, such as a property or financial account, to secure the loan.
Because of that, many banks view personal loans as being higher risk than other loan types, and some implement restrictive policies that dictate the loan’s term, amount, and repayment options. That said, another way that a personal loan can affect your credit in a positive way is that it can diversify your credit mix if your typical debt stems from credit cards or secured loans. However, the effect is somewhat minimal.
Many borrowers look to personal loans for debt consolidation because banks and lenders don’t put limitations on what the funds can be used for. Loans generally come with lower interest rates than credit cards and some other types of debt, making them a good option to consolidate higher-interest accounts.
How Can a Personal Loan Build Credit?
Personal loans can have a positive impact on your credit in a few ways, starting with your payment history.
Reporting a Positive Payment History
Once you’ve been approved for a loan and start making payments, the bank will report those payments to one or more of the three major credit reporting bureaus. Over time, the on-time payments recorded on your credit report will improve your score by showing responsibility for loan payments over time.
Reducing Revolving Debt Amounts
Credit cards are considered revolving debt because the account remains open, and the borrower can repay and re-borrow as many times as they like. But, while they aren’t inherently bad, lots of credit card debt can make a borrower appear riskier to lenders. Using a personal loan to consolidate those accounts reduces the borrower’s revolving debt and helps reduce their credit utilization by clearing the card balances.
What Kind of Personal Loan Can Improve My Credit Score?
Almost any personal loan can improve your credit score, as long as the account is paid on time and you follow the terms of the agreement. Debt consolidation loans are the most likely to improve your credit because they are used to combine debts from other accounts with higher interest rates and can make the payoff process much less stressful. However, failing to pay, making late payments, and other issues can set the borrower back further than they may think.
Obtaining a secured personal loan comes with risks due to the inclusion of collateral. However they can help diversify your credit types and provide a built-in incentive to continue making on-time payments.
What is a Credit-Builder Loan, and Will One Improve My Credit Score?
Credit-builder loans can be a tool to help people with little to no credit history obtain a loan, but they aren’t without their disadvantages. Many credit-builder loans have a repayment term of 24 months, but borrowers can’t gain access to the loan amount until they have made all of the payments upfront.
So, a borrower needing a $10,000 loan would make regular payments until they accumulate that amount with the lender, at which point they receive the loan funds. These loans are generally not the best for people with established credit, even bad credit, as they often come with steep fees and other costs that more traditional financial products do not. They’re also not great for borrowers who need loan funds immediately, as they must first “pay into the system.”
Is Taking Out a Personal Loan to Improve My Credit Score Worth It?
Taking out a personal loan to improve your credit score can be a good idea, but only if you understand the terms and are sure you can repay the loan without being late or defaulting. Personal loans can also be a great way to consolidate your other debts, and debt consolidation loans are one of the more responsible ways to use a loan to improve your credit. However, making on-time payments consistently and repaying the loan within the agreed-upon terms is key.
What Are the Risks When Taking Out a Personal Loan to Improve My Credit Score?
All loans come with some degree of risk, especially if your financial situation isn’t as stable as you’d like. Failing to make loan payments on time, defaulting, and other problems can quickly tank your credit score and will overcome any positive impact you experience from making payments. Additionally, applying for a loan involves a hard credit inquiry, which will remain on your credit report for two years and will impact your score.
Personal Loan Alternatives That Can Help Increase Your Credit Score
Personal loans aren’t the only financial product that can help you build your credit score. You may also want to consider a balance transfer credit card, which will allow you to consolidate other credit card debt into one account. That usually makes the debt easier to pay off and could lower your monthly payment. Secured credit cards can be another tool to boost your credit score. Banks offer these cards with a credit limit that is secured by some sort of collateral from the borrower, usually a deposit account or similar investment.
