A Personal Loan Can Help You Build Credit — Here’s How

Though there are plenty of good reasons to get a loan, improving your credit score is one that deserves some serious consideration.

You’ll find that most banks and online lenders offer personal loans, which you can apply for and pay back in monthly installments over a specific period of time (term). Since personal loans can be small or large and used for lots of different purposes, they’re valuable tools for strengthening your credit score and history. But if you overextend yourself, taking out a personal loan could end up hurting your credit.

Here’s a closer look at how to get a loan, along with the ways a personal loan can help your credit score, help you save money, and generally boost your financial picture.

How a personal loan can boost your credit

It’s important to understand some of the factors that are evaluated when the three major credit bureaus — Experian, Equifax, and TransUnion — calculate your credit scores. These include payment history, credit utilization, how long you’ve been using credit, the types of credit accounts you have, and how many new accounts you’ve recently opened.

Taking out a personal loan can help with several of these areas, which can then translate into an increase in your overall score. Here are four specific ways a personal loan can do this.

1. Responsible debt consolidation

When you utilize a personal loan for debt consolidation, you can pay off all the creditors in one shot. You take on a new type of debt that includes all of the balances you just paid off, plus a simple interest calculation that’s added to the total amount borrowed. You’ll make one monthly payment for a specific period of time, and at the end, your loan will be completely paid off. Ideally, this new personal loan also has a lower interest rate than your existing debts.

If you have a revolving line of credit, which is the case when you have a credit card, the amount you owe in payments and the total credit card balance can change from month to month. Interest is compounded daily, which also adds more to your total balance from statement to statement and credit cards tend to have high interest rates.

With a large medical or home repair bill, you may have to pay off the amount within a short period of time. This can lead to large payments you may not be able to afford. You might have the option of opening a specialized credit account that charges high amounts of interest.

It may be tempting to put more charges on your credit cards once the balances are down to zero. However, this will only increase the amount of credit card debt and overall debt you owe, since you’ll be paying on your personal loan for at least a few years. Adding more debt to your credit report won’t help your score.

2. Improving credit utilization

Credit utilization is the ratio of the amount of revolving credit you have available to you versus how much of it you’re using. It’s calculated by dividing how much you owe by your total limit. For example, if you have two credit card accounts with a maximum limit of $1,000 combined and balances that add up to $200, your credit utilization would be 20% ($200 / $1,000 = 0.20 x 100 = 20%).

Since a personal loan is an installment loan and not a line of revolving credit, it doesn’t count toward your credit utilization. If you were to consolidate all of your credit cards into a personal loan, your credit utilization ratio would get a boost, even though the total amount you owe remains the same. You’d also be diversifying your credit mix by adding an installment loan.

3. Establishing a positive payment history

If your payment history hasn’t been the most reliable, chances are this is an area of your credit score that you want to focus on improving. A personal loan can help by giving you one payment instead of several smaller ones you have to budget for and keep track of month to month.

When you have only one payment to remember, the chances of making on-time payments every month is much better. Using autopay or setting up a way to have payments withdrawn from your account each month will also help you stay on track.

4. Building your credit

There are specific types of personal loans that you may be able to get even if you have limited or poor credit. These credit-builder loans are designed to help you build a history of making payments, all with very little risk to the bank that issues the loan.

Credit-builder loans work a little differently than other personal loans. Instead of the lender giving you money to spend upfront and then pay back, you pay the lender a specific amount every month. It reports to the credit bureaus that you’ve made a loan payment, then puts this money into an account. At the end of the loan term, you get the total amount you paid on the loan, minus interest.

In some ways, this type of loan is like a savings account that helps you build your credit and payment history while you stash money away.

How a personal loan can hurt your credit

While a personal loan can be useful, it’s important to consider both the pros and cons of applying for a loan. There are three potential drawbacks you should know about:

1. Credit inquiries can lower your score

When you apply for a personal loan, the lender will run a hard credit inquiry when they review your application. Hard inquiries can lower your credit score. According to myFICO, most people will see their credit scores decrease by up to five points per hard credit inquiry.

To minimize the impact on your credit score, look for lenders that offer rate quotes with just a soft credit check. Soft credit inquiries don’t affect your credit, so you can see potential interest rates without submitting a full application. Once you find a lender that offers competitive rates and terms, you can move forward with their application process.

2. Late payments wreck your payment history

Your payment history is the single biggest factor in determining your credit score. If you take out a personal loan and miss payments, you could significantly damage your credit.

According to Equifax — one of the three major credit reporting bureaus — a 30-day delinquency could cause your score to drop by as much as 110 points. If your credit score was 780 — a score in the “very good range” — your score would drop to 670, putting you in just the ‘good” range. If you were to apply for a credit card or loan after your score dropped, you may struggle to get approved or be subject to higher interest rates than you would’ve gotten with a better credit score.

3. Having new credit affects your score

New credit determines 10% of your credit score. Fresh accounts can make lenders nervous because they may think you’re taking on too much new debt and will struggle to keep up with the payments. If you don’t have a lengthy credit history, taking out a personal loan can cause your score to drop. 

If you’re thinking about applying for a personal loan, limit how often you apply for new forms of credit that bring down the average age of your accounts. Loan companies and other creditors use the length of your credit history as part of their evaluation. 

How to protect your credit score when you apply for a loan

Before taking out any kind of loan, get copies of all three of your credit reports. This will help you understand what a bank is looking at when evaluating your application and give you the chance to dispute any errors before you apply. Doing this can also help give your credit score a boost if there were mistakes on your reports.

You should also look at your monthly income and expenses, set up a budget, and make sure that the repayment plan fits your budget and lifestyle. This will help ensure that you’re not taking on more debt than you can comfortably and reliably pay back. An online personal loan calculator may help you come up with an affordable figure.

FAQs about personal loans

Bottom line

Is taking out a personal loan the right financial strategy for your credit score? Only you can answer that question since everyone's personal finances are unique. Hopefully, this article gives you some things to consider and research as you think through your options. If you decide to move forward in applying for a loan, make sure to check out our list of the best personal loans.