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How to Use a Personal Loan to Build Credit
A good credit score can work in your favor when applying for loans, renting an apartment or even getting a cell phone in your name. The better your score, the easier it may be to get approved at the best rates or avoid paying steep security deposits.
When you have poor credit or a thin credit file, meaning you lack sufficient credit history to generate a credit score, taking out a personal loan is one way to potentially turn things around. Personal loans can help with building positive credit history when used responsibly. Collectively, Americans had borrowed $305 billion in personal loans through the second quarter of 2019, according to Experian.
If your credit score could use some improvement, here’s what you need to know about using a personal loan to do it.
What’s In Your Credit Score?
Similar to credit cards, car loans or lines of credit, personal loans can show up on your credit reports. The information in these reports are used to calculate your credit scores.
FICO scores, the most widely used credit score model, are based on five key factors:
- Payment history (35% of your score)
- Credit utilization (30% of your score)
- Credit age (15% of your score)
- Credit mix (10% of your score)
- Inquiries for new credit (10% of your score)
In terms of what each one means for your credit score, paying on time carries the most weight while making payments late or skipping them entirely does the most damage. Credit utilization, which refers to the amount of available credit you’re using, follows close behind. Keeping balances on credit cards, loans and lines of credit low relative to your credit limit can have a positive impact on your score.
Credit age refers to how long you’ve been using credit while credit mix means the various types of credit you use. And inquiries for new credit show up on your credit history when a lender does a hard pull of your credit report.
How to Choose a Personal Loan to Build Credit
Choosing a personal loan is an important decision. After all, you want to ensure that you get the best interest rate and loan terms possible.
The first step in finding the right loan is checking your credit report and score. This can give you an idea of what your approval odds are for a personal loan and what interest rates you might pay. You can check your credit report for free through AnnualCreditReport.com. Services like Experian Credit Boost let you see your FICO credit score for free.
Next, you can move on to comparing personal loan lenders. When comparing lenders, it’s important to look at the following:
- Minimum credit score requirements. Many, though not all, personal lenders state up front the minimum score they require borrowers to have. Checking this can help you filter out lenders that aren’t a good match.
- Minimum loan limits. If you’re using a personal loan solely to build credit you may only be considering a small loan of a few thousand dollars that you can pay back fairly quickly. Different lenders can have different minimums they expect you to meet to borrow.
- Loan terms. Take time to review repayment terms to see what fits your budget. A shorter term usually means higher monthly payments, while a longer term means a lower payment but you might pay more in interest overall.
- Interest rates and fees. Personal loans have to be repaid with interest and some lenders charge origination fees. Reading through the rates and fee schedule can give you an idea of how much you’ll pay to borrow.
One more thing to consider is whether the lender reports loan activity to the credit bureaus. The only way your loan can have an impact on your score is if your account is showing up on your credit reports.
Once you’re approved for a personal loan, you can start using it to build credit. Remember, the most important thing you can do is to make your payments on time. Scheduling automatic payments or setting up due date reminders can help you avoid missing a due date. While a personal loan may not be an overnight fix for poor credit, it could help you see an improvement in your scores over time.
How to Use Personal Loans
Rebecca Lake is a freelance writer specializing in personal finance, credit and debt. She’s a contributor to U.S. News and World Report, Forbes Advisor and The Balance and her work has appeared online at CreditCards.com, MyBankTracker, Money-Rates.com and dozens of other top publications.