One of the factors lenders look at during loan processing is the applicant’s credit score. It’s a good idea to review your own credit reports before applying for a loan to see if there are any errors that can be corrected and possibly increase your credit score, if needed.
If your credit score is not as high as you’d like it to be, it may seem counterintuitive to consider taking on debt to increase it, but it’s a method that has some merit. Making timely payments on a personal loan may have a positive effect on a person’s credit score. Let’s take a look at what factors go into calculating a credit score and how taking out a personal loan can affect it.
Does a Personal Loan Help to Build Credit?
If a borrower makes on-time, regular payments on a personal loan — or any loan, for that matter — that information will typically be reflected on their credit history and can be one way to build credit. It’s a good idea to ask the lender if they report payment history to the three major credit bureaus, Experian®, Equifax®, and TransUnion®. If the lender doesn’t report the information, it won’t affect the borrower’s credit positively or negatively.
Recommended: How to Build Credit Over Time
When Does a Personal Loan Help You Build Credit?
Someone who doesn’t have much of credit history or wants to improve their credit score because they understand the importance of good credit might wonder “Will a personal loan build credit?” It certainly can be one method to do so, but only if handled responsibly. A personal loan to build credit can be an effective tool if the payments are made regularly and on time.
The terms “credit” and “credit score,” while closely related, are not the same. Generally, when the term “credit” is used, it’s referring to a credit report, which is a summary of a person’s financial history. The information contained in a credit report is what affects your credit score. So, while the two are different, they’re used together in lending and other credit matters.
To see where improvement can be made in how you handle your finances, you can review your credit report for individual elements that figure into the calculation of your credit score. Credit score updates can happen every 30 to 45 days, depending on when lenders report payment information to the credit bureaus, and small fluctuations are normal.
Your Payment History
The way you handle debt is the most important factor in determining your credit score. It accounts for 35% of a person’s FICO® Score. How you’ve repaid — or not repaid — debt in the past is considered a good indicator of how likely you are to repay future debt and is something lenders look at closely.
Missing payments or making late payments on a personal loan might hurt your credit score.
Your Credit Utilization Ratio
Second only to payment history, having a large debt-to-credit ratio, also called your credit utilization ratio, can be a damaging factor to your credit score. It accounts for 30% of the total FICO Score and takes into account both revolving (e.g., credit cards) and installment debt (e.g., personal loans).
This ratio is calculated by dividing how much do you currently owe by the total credit available to you. Credit cards offer a good example: if you have a monthly limit of $10,000, and typically carry a balance of $9,000 on your card each billing period, your utilization ratio would be 90%.
The Age of Your Credit History
Since the age of your credit history is a factor in your credit score, the ideal situation is to start building credit early. That’s not always feasible, though. If you don’t have much of a credit history yet, a personal loan to build credit can be useful.
As long as the loan’s payment history is positive, the longer a loan is listed on your credit report, the more likely it is to have a positive effect on your credit score.
Adding Different Types of Credit
An additional factor that can impact your credit score is the mix of different types of credit you might have, such as credit cards, student loans, and mortgage loans. In general, your credit score will benefit from a healthy mix of different kinds of debt on your credit report.
Having both revolving debt, like credit cards or lines of credit, as well as installment debt, such as a personal loan, can have a positive effect on your credit score if you’re making regular, on-time payments on the debts.
If you currently only have credit cards, adding a personal loan to your credit mix can go a long way in establishing multiple types of credit and potentially boosting your credit score.
Recommended: Personal Lines of Credit vs Credit Cards
When Doesn’t a Personal Loan Help You Build Credit?
We’ve covered some of the ways a personal loan can help build credit, but there are situations in which a personal loan might have a negative effect on your credit.
Making late payments on any type of debt, including a personal loan intended to build credit, will likely have the opposite effect. Lenders place a great deal of importance on a person’s payment history. If a lender sees a lot of late payments or missed payments on your credit report, they are probably more likely to see you as a credit risk.
Short Term Loan
Short-term loans can be predatory loans. They are meant to help someone make ends meet until their next paycheck, but it can be next to impossible to actually pay off because of the extraordinarily high-interest rates typically charged on them.
Lenders of these types of loans may not report payments to the credit bureaus, essentially negating any effect your responsible repayment might have. If you’re thinking of taking on debt to boost your credit score, a short-term loan is probably not the best option.
Personal loans have many direct benefits – access to cash, predictable payments, consolidating high-interest debts – but their secondary impact on your credit score can be meaningful for your borrowing future. Making your personal loan payments on time may help you improve your credit score and your future borrowing options.
SoFi Personal Loans are unsecured loans that offer competitive, fixed rates and no fees. With a variety of terms to fit different budgets, there may be an option that works for your unique financial situation.
Do personal loans raise credit scores?
If repaid on time with regular payments, a personal loan is one financial tool that might have a positive effect on a person’s credit score. There are a variety of factors that go into the calculation of a credit score, though, and it’s wise to pay attention to all of them.
How long does it take to build credit with a personal loan?
Building credit means building a history, which doesn’t happen overnight. It might take about six months to see results from diligently making on-time personal loan payments.
Is taking out a personal loan bad for credit?
Taking on new debt can have a temporary negative effect on your credit score. But over time, while making regular, on-time payments, a personal loan has the potential to help your overall creditworthiness.
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