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Updated on Thursday, February 21, 2019
If you’ve been trying to build up your personal credit, you may have considered using a personal loan. Taking out a personal loan could show creditors that you can responsibly handle different kinds of debt and follow the terms to which you and your lender have agreed.
But how successful you are depends on your ability to pay the loan back within the given term limits. Here’s what you should consider before taking out a personal loan to build credit.
Pros vs. cons: Using a personal loan to build credit
There are both pros and cons to taking out a personal loan in an attempt to increase your credit score:
- Add to your credit mix: A personal loan could help you diversify your credit mix, which accounts for 10% of your FICO score.
- Stay current on payments: You could use a personal loan to refinance a debt or consolidate debts to a lower interest rate. Doing so could help ensure you stay current on payments, which positively impacts your credit.
- May not have to put down collateral: An unsecured personal loan doesn’t require you to put up collateral to secure the loan. That means your house or other assets can’t be taken away if you default.
- Lower your credit utilization ratio: A personal loan can also lower your credit utilization ratio if you pay off your credit card balance with your loan and keep the card open. Credit utilization is important factor in your FICO score, and it is basically the amount you owe divided by the total amount you have available to you. Personal loans don’t count toward it.
- Fees, fees, fees: Depending on your credit score, you could be paying hefty interest fees over the length of the loan, in addition to any other fees your lender charges, such as prepayment penalties, late fees and origination fees.
- Could increase your debt-to-income ratio: Taking out a personal loan could change your debt-to-income ratio. This could make future lenders less likely to let you borrow funds until some, or even most, of your personal loan is paid off.
- Strict payment schedule: Personal loans are often issued for a period of between 24 to 60 months and offer little flexibility when it comes to adjusting payments. So if you lose your job or face other financial struggles, your lender may be unwilling to work with you to reduce or delay payments.
Is using a personal loan to build credit right for you?
A personal loan might make sense for you if your goal is to diversify your credit mix or lower your credit utilization ratio by paying off a credit card. It’s also a good option if you plan to use the funds at a lower interest rate to pay off other debt that’s charging you a higher interest rate.
A personal loan to build credit might not be a good option if you’re already struggling with paying off debt, if you have no prior credit history or if you could get a credit card with a lower rate of interest instead. If you can’t get a reasonable interest rate, a personal loan might not be a good choice, said David Gokhshtein, a New York-based member of the Forbes Finance Council.
“In most cases, people in this scenario already have lower credit scores, leading to very high interest rates they could be paying off indefinitely,” he said. “If the debt gets sent to a collection agency, it will further damage the person’s credit score.”
That said, it’s important you have a clear picture of your financial situation. Consider the following questions:
- Is your credit score good enough to qualify for competitive interest rates?
- Can you afford the cost of a personal loan?
- Is taking out debt and repaying it with interest worth it to build your credit?
- Do you have a good use for the funds?
Answering these questions could help you decide whether or not to move forward with this option.
How to take out a personal loan
The first thing you should do if you decide to get a personal loan is to check your credit score. A FICO score of 700, on a range that spans 300 to 850, indicates you have good credit and would be likely eligible for a variety of loan offers, including a personal loan at a reasonable rate of interest. Because FICO scores are seen as an accurate reflection of your creditworthiness, lenders rely on them in 90% of all decisions.
You’ll want to research your options for lenders before committing to a loan, as well. You can use MagnifyMoney’s personal loan marketplace to compare lenders. You may also look to local banks or credit unions.
If possible, apply for preapproval from your top lenders of choice. Preapproval will allow you to see rates and terms you might qualify for with a soft credit check, which won’t affect your credit score.
Consider the following when weighing your loan options:
- Lender perks, such as support in case of job loss
Once you decide on a lender, you can submit to a hard credit check to see your final rates and terms. Depending on the lender, you could get loan funds within a few business days.
Others strategies to improving your credit
Consider the following ways to build credit without accumulating any additional debt:
Get a credit builder loan. With this type of loan, the money you borrow is deposited into an interest-bearing account. As you make payments on the debt, your payments are reported to the credit bureaus. Once you pay off your debt, the loan funds and the interest they earned are released to you.
Charge only what you can pay in full each month. If you have a credit card, you could use to work on your credit. Just make sure you pay off the card in full each month. “It is imperative to create and use a simple budget to make sure you follow this rule,” said Freddie Huynh, the San Francisco-based vice president of credit risk analytics at Freedom Financial Network. “Being able to pay your bills on time is the most important factor in the calculation of your credit score, accounting for 35 percent.”
Review your credit reports regularly for accuracy and correct any errors you find. You can access credit reports from each of the three main credit reporting agencies once a year for free at www.annualcreditreport.com. “If any report shows any inaccuracy, follow the directions on each agency’s website to correct it,” Huynh said.
The bottom line
Carefully consider your options before taking out a personal loan. You should have a clear idea of how you’ll use the loan funds and what the total cost of the loan will be. Most importantly, if your credit has been damaged by poor financial habits in the past, you need to consider whether or not a personal loan is only a temporary solution to a larger problem.
“My biggest concern with anyone considering a personal loan to pay off high interest credit cards is that they are focusing on the symptom, not the cause,” said Todd Christensen, the Boise, Idaho-based education manager at Money Fit by DRS. “If the borrower is disciplined, it might make sense; otherwise, debt management through a nonprofit credit counseling agency could make more sense.”
While a personal loan can be one part of the credit building or repairing process, it’s not your only possible solution. In fact, Christensen said taking out a personal loan could be part of a multi-pronged strategy to boosting your credit. Still, a personal loan on its own could help depending on your finances — given that you properly research lenders, stay disciplined during repayment and take extra care of your money throughout the process.