Personal loans are one of many debt products you can use to build credit. However, they may not be the best option if you have little to no credit or a series of past credit missteps, as these scenarios mean you may not get the best loan terms. Read on to learn more about how a personal loan affects your credit and other alternatives you can use to boost your credit health instead.
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How a Personal Loan Affects Your Credit
There are five components to your credit score. Here’s how a personal loan can impact each:
- Payment history (35 percent): Your payment history will improve as you make payments on your loan over time. In turn, your credit score could start to increase.
- Amounts owed (30 percent): A personal loan won’t impact your credit utilization per se, but you want to responsibly manage your other outstanding debt obligations to keep your credit score up to par.
- Length of credit history (15 percent): An established credit history that reflects responsible use of credit is good for your credit health. If you’re a credit newbie, you can start building your credit with a personal loan.
- Credit mix (10 percent): Creditors and lenders like to see a healthy mix of revolving (i.e., credit cards) and installment accounts (i.e., loans). A new personal loan can strengthen your credit mix if you have credit cards but don’t have other loans in your credit profile.
- New credit (10 percent): Each time you apply for a new credit card or a loan, a hard inquiry is generated and could drop your score by a few points. Fortunately, the impact is temporary and won’t do too much damage if you refrain from applying for too many new credit accounts in a short period.
Benefits of Personal Loans to Build Credit
A personal loan can be a viable option to build credit for several reasons:
- You could improve your payment history and credit mix.
- Your credit utilization could improve if you pay off credit card debt.
- You could save a bundle in interest by paying off high-interest debt.
Risks of Personal Loans to Build Credit
While you can use personal loans to build credit, this approach is not without risk. In fact, it could do more harm than good in some instances. Here’s why:
- You could spend a fortune in interest over the life of the loan if you have less than perfect credit. While there are lenders that market unsecured personal loans to credit-challenged individuals, they often come with an exorbitant interest rate.
- The loan term could be too brief. You’ll generally get a steep monthly payment that could stretch your budget too thin if the repayment period is short.
- If you fall behind on your loan payments and your account reaches 30 or more days past due, the lender could report the delinquency to the credit bureaus – Experian, TransUnion and Equifax. Unfortunately, a single late payment could drop your score by up to 100 points. The higher your credit score was before the late payment appeared on your credit report, the more significant the impact.
- You may not get credit for your loan payments. Not all lenders report to the credit bureaus, which means managing your personal loan responsibly won’t help improve your payment history and build credit.
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When to Use a Personal Loan to Build Credit
It could be sensible to use a personal loan to build credit if you get approved for a loan product that meets these criteria:
- Competitive interest rate
- Repayment term between two to five years
- Reports to the three primary credit reporting agencies
- Has minimal fees
Otherwise, it may be best to consider other options to build credit.
When to Consider Other Options to Build Credit
If a personal loan isn’t a good fit to build credit, consider these alternatives:
- Credit-builder loans: an installment loan that’s designed to help individuals with varying backgrounds build credit
- Secured credit cards: they work just like a traditional credit card but require a refundable deposit to establish your credit limit
- Home equity loan or home equity line of credit: lets you borrow against the equity you’ve built up in your home and uses your home as collateral
Explore Credit Builder Loans as an Alternative
- Submit an online application for a credit builder account without impacting your credit score.
- Upon approval, choose the account with the monthly payment amount and term that works best for your financial situation.
- Self will move the funds to a certificate of deposit that will remain locked until you pay off the account.
- Make the required monthly payments on time each month. Self will report this information to the credit bureaus to improve your payment history.
- At the end of the payment term, Self will unlock your CD, and the funds are yours to keep (minus any applicable interest and fees).
Where Can You Get a Credit Builder Loan?
Some banks and credit unions offer credit builder loans. However, you should consider Self as the platform offers three account options to choose from:
- Small Builder: comes with a 24-month term, $25 monthly payment, and you’ll receive $520
- Medium Builder: comes with a 24-month term, $35 monthly payment, and you’ll receive $724
- Large Builder: comes with a 12-month term, $48 monthly payment, and you’ll receive $539
It only takes a few minutes of your time to get started, and applying won’t generate a hard inquiry on your credit report. Start working towards the credit score you deserve by opening a Self credit builder account today.