When used responsibly, personal loans may be able to help you build and maintain a good credit score. Several factors go into determining your credit score, and making payments on a personal loan can help with a few of them.
Before you apply for a personal loan, though, it's also important to consider the potential drawbacks. Here's everything you need to know.
Ways a Personal Loan Can Help Improve Credit
Personal loans are among the most versatile forms of credit because you can use them for just about anything. And if your personal loan payments are reported to the three national credit bureaus (Experian, TransUnion and Equifax), the positive payment history associated with the loan will help you build credit. It's possible, however, that taking out a personal loan might do more harm than good—especially if you can't afford it.
Your FICO® Score☉ uses five factors to determine the health of your credit. Here are the three factors that can be impacted positively by a personal loan:
- Payment history: Your payment history is the most important indicator of responsible credit use and makes up 35% of your FICO® Score. As you make on-time payments on your personal loan, you'll be building a positive payment history and potentially improving your credit score.
- Amounts owed: Using a personal loan to consolidate credit card debt can significantly improve your credit if it helps you reduce your credit utilization ratio. You can calculate your credit utilization by dividing your credit card balances by their credit limits. For example, a $1,000 balance on a card with a $2,000 limit has a 50% utilization rate. By paying off the card with a personal loan, you reduce that percentage to 0%, which can help increase your credit score. The amount of installment debt you have still affects your scores, but not nearly to the extent that a high credit utilization ratio does.
- Credit mix: Your credit score also considers how well you manage different types of credit. For example, someone who has credit cards, student loans, an auto loan and a mortgage loan may be viewed more highly by lenders than someone who has only ever had credit cards, even if they've both used their credit responsibly. Adding a personal loan to your credit file can bolster your credit mix and help your credit score.
Ways a Personal Loan Could Hurt Your Credit
While there are some clear benefits of using a personal loan to build credit, there are some potential pitfalls to watch out for:
- Missed payments: Taking on debt you can't afford to pay back could cause significant damage to your credit score. Consider applying for a personal loan only if you're confident you'll have the means to make your monthly payments on time for the duration of the loan's repayment period.
- Credit inquiry: When you apply for a personal loan, the lender will typically run a hard inquiry on your credit report. Each inquiry typically takes a few points off your credit score. But if you've applied for multiple credit accounts in a short period, it could compound that impact and make it harder for you to get credit in the future.
- Length of credit history: Every time you open a new loan, it reduces your average age of accounts, which can decrease your credit score slightly. For example, if you've had a credit card for 10 years and an auto loan for three years, your average age of accounts is 6.5 years. Add a brand-new personal loan, and that average goes down to 4.33 years. The length of your credit history, which also considers your oldest credit accounts and the last time you used credit, makes up 15% of your FICO® Score.
It's also important to consider that personal loans cost money in the form of interest and other fees. If you're consolidating credit card debt, you may be able to get a lower interest rate than what you're paying now and save money that way.
But if you're applying for a personal loan solely to build credit, consider the interest charges and whether there's a better (and cheaper) way to build credit, such as by using a credit card and paying it off in full every month before you accrue interest.
Also, if you use a personal loan to consolidate credit card debt, make sure you don't rack up another balance on your credit cards. Doing so may put you even deeper in debt, which can damage your overall financial well-being, and risks damaging your credit.
What Credit Score Do You Need to Get a Personal Loan?
You can qualify for a personal loan with just about any credit score. But it's important to keep in mind that a better credit score will give you access to a broader range of lenders and lower interest rates.
For example, there are lenders that specialize in working with people with bad credit, but you may end up paying triple-digit interest rates with some of them, which may not be worth it.
It's also important to keep in mind that lenders look at more than just your credit score to determine your eligibility and loan terms. Other factors that lender consider include:
- Job stability
- Other debt payments
- Negative items on your credit report
- Whether you have a cosigner
In some instances, lenders may require collateral in the form of savings before they'll approve you for a loan. While this can help you qualify for a lower interest rate because it reduces the lender's risk, it can be challenging if you're short on cash.
If your need for a personal loan isn't immediate, it may be a good idea to work on improving your credit before you apply. This can include paying down credit card balances, getting caught up on past-due payments, paying upcoming bills on time and avoiding new credit unless it's necessary.
How to Get a Personal Loan
You can get a personal loan from a variety of sources, including traditional banks, credit unions and online lenders. If you have stellar credit, you'll have more options and it can be easy to get approved for a personal loan.
If your credit isn't in great shape, though, your options may be limited and you may have difficulty getting approved with favorable terms.
As such, it's crucial that you take the time to shop around and compare personal loans from several lenders before you apply. Many of these lenders allow you to get prequalified with a soft credit check, which won't impact your credit score. This process allows you to view and compare loan offers, including interest rates, repayment terms and more.
Take your time with your research, and you'll have a better chance of getting the right loan with the best terms available for you.
Monitor Your Credit Regularly to Maintain Good Credit
Before and after you apply for a personal loan, it's essential to monitor your credit. Doing so will not only help you understand which areas of your credit history that you need to address, but will also give you the chance to spot potential new issues and fix them before they damage your credit score.
Experian's credit monitoring tool provides free access to your FICO® Score, plus an updated Experian credit report every 30 days. You'll also get real-time alerts whenever a new inquiry or credit account gets added to your Experian credit report, so you can report potential fraud as it happens.
As you focus on building and maintaining an excellent credit history, you'll be in a much better position to qualify for affordable credit in the future when you need it.