In brief, personal loans can be an effective way to build credit. The catch is you only can qualify for reasonable rates when you already have good credit. If you have poor credit or no credit at all, you will probably only qualify for loans with high rates and expensive fees. Here is a list of the best personal loans currently available. In such a case, you should probably consider other credit building methods. This article will explain how personal loans can help and what alternatives you should also consider.
Tip: Using personal loans to rebuild your credit history is a double-edged sword. Although making regular payments on a personal loan can help, taking on debt can be expensive and push you into more serious financial difficulties. Make sure you can afford the monthly payments before you get a personal loan.
Building a Favorable Credit History
According to MyFICO.com — the company behind the most commonly used credit score by lenders — your payment history is the single largest factor in calculating your FICO score. A whopping 35 percent of your score is determined by how promptly you pay your bills.
But there are many options of loans for bad credit that could help. By taking a personal loan with lenders that report to major credit reporting bureaus, such as NetCredit or Rise, you can nudge your credit score in the right direction. Why? Personal loans are repaid over months or years, which gives you plenty of time to establish a pattern of on-time payments.
Tip: If you decide to get a loan to help your credit score, avoid payday loans. They don’t report to credit bureaus and will do nothing to rebuild your credit.
Alternatives to Personal Loans
Not everyone can (or should) use a personal loan for building credit. There are some alternative ways to improve your credit that are also worth looking into.
Obtain a (secured) credit card
Many people choose to live without a credit card after bankruptcy. But everyday activities, such as renting a car or booking a hotel, can be difficult without a credit card. If you qualify for an unsecured credit card after filing for bankruptcy, the terms you receive will be less than desirable: low credit limits, stiff fees, and high interest rates.
Secured credit cards, such as First Progress Platinum Elite Mastercard or USAA’s Platinum Mastercard (only for members of the armed forces and their families), look and work like regular credit cards but are available to people with poor credit. They usually offer lower interest rates and few or no fees because the credit limits are dictated by the guaranteed deposit you provide.
However, if you just filed for bankruptcy, you probably don’t have much cash lying around to deposit as a guarantee. A personal loan allows you to obtain the cash you need to make a substantial deposit and receive a reasonable credit limit of $1,000 or $1,500.
SuperMoney Tip: Credit score algorithms also look at your debt-to-available-credit ratio. In fact, credit utilization accounts for 30 percent of your FICO score. Once you have a credit card, you could further improve your credit score by maintaining low balances on your secured credit cards.
Using a credit-builder loan
The advantage of a credit-builder loan, such as Self, is that you don’t need good credit to qualify. Its entire purpose is to help people who don’t have a credit history yet, build credit. What you do need is proof that your current income is enough to cover the payments.
Note that credit-builder loans are most effective when used by consumers who don’t have a credit history. If you are dealing with a lot of debt and have a history of missed payments, a credit-builder loan will have less impact on your score.
Frequently asked questions about personal loans and building credit
Can a loan help to build credit?
Taking out a personal loan can help to build credit, with some caveats. We will go into more details about this option later on, but what you need to know is that your ability to build credit off a loan is largely contingent on your ability to pay it.
If you can’t make payments on time, your credit score may suffer. That’s why it is important to understand the terms of the loan you are taking out – not only the payment amount but also the interest rate and how long you have to pay it off over. Given the right circumstances, though, a personal loan will help to build credit.
Can you use a small loan to build credit?
Sometimes a bigger loan is not an option, either because a lender won’t allow you to take one out or it’s not the best decision for you financially. While a bigger loan might have more of an impact, you can also use a small loan to build credit. It’s important to make sure the terms and conditions are still agreeable, though.
That small loan could easily snowball into something much larger if the loan terms are bad. You also want to make sure the lender reports to the credit bureaus. Payday loans are an example of a small loan that typically doesn’t appear on your credit report — so it won’t help your credit score — and can balloon into a large debt.
Will a personal loan help build your credit after filing for bankruptcy?
Filing for bankruptcy clears many of your personal financial obligations, but it also places you in credit purgatory. Whether you declare Chapter 7 or Chapter 13, bankruptcy leaves a stain on your credit profile that will stay with you for up to 10 years.
But you don’t have to wait 10 years to rebuild your credit. A personal loan, especially from your local credit union or an online lender, can be a powerful tool to help you regain your financial footing and rebuild your credit.
How to Build Credit with a Personal Loan
Personal loans can be helpful to build up bad credit. Being on time with your payments every month will help balance out any poor payment history for creditors who typically don’t like to provide second chances.
When you find a personal loan you are comfortable with, create an atmosphere you can be successful in. Set up automatic monthly payments so that you don’t have to worry about missing a payment.
Credit card debt consolidation
You can also use your personal loan to consolidate current credit card debt with a lower interest rate. This is because consolidation lowers your credit utilization ratio or the amount of money you owe on all of your credit lines. As long as you keep your credit cards open, doing so will positively impact your score.
Using secure investment instruments
The drawback of using a small personal loan to build credit is that you may be tempted to buy things you cannot afford. You can minimize the cost of a personal loan by investing the funds in a secure investment instrument, such as a CD, and use the loan as a tool to save money.
SuperMoney Tip: Notice the interest you pay on the loan will exceed the income you generate from the CD. This is not a good investment idea. The primary goal (and only potential benefit) is to build a positive payment history.
Many banks and credit unions will provide loans secured by CDs. The money you borrow is deposited directly into the CD account while you make payments on the loan each month. You are essentially borrowing from yourself. This option is great for lenders because there is no risk for them.
After you have repaid the loan, plus whatever interest is charged, the bank releases its hold on your CD. Once your CD matures, you receive earned interest along with your original deposit. In the meantime, your bank or credit union reports your on-time payments to the three major credit reporting agencies, which could help your credit score.
If your bank or credit union doesn’t offer CDs, or if you cannot qualify for a bank or credit union loan, don’t despair. You can obtain a personal loan and use the money to purchase a CD from any financial institution that you choose. If you get your loan through an alternative lender, make sure they report to at least one credit bureau.
Of course, taking out a personal loan has no advantage if its effect is to hurt your credit. As we mentioned before, you have to pay close attention to the loan details and confirm they are favorable to you. Here are some of the terms you want to look out for:
Length of time: How long do you have to pay off the loan? Some personal loans may give you just a week with the expectation to pay in full. If you don’t have the ability to do that, you could end up swimming in more debt.
Interest rates and fees: Having a high interest rate or significant late fees could make payments more difficult than they might appear at first glance.
Major credit bureau reporting: Does the lender you are considering report to the major credit bureaus? If they don’t, keep looking because it will not help your credit score if the credit bureaus don’t know about it.
Working with your current credit lines
You may not need to open a credit card or take out a loan if you have existing credit lines. Use your current debt as a way to start making monthly payments in full and proving your reliability to creditors. As long as your credit source reports your payments to the major bureaus, this can positively impact your score.
The Basics of Using Loans for Credit
Now we have discussed some strategies to build your credit, let’s outline some important questions about how things work in general.
What goes into creating your credit score?
While the calculations for your credit score may feel mysterious, the equation for it is pretty straightforward. The credit scoring models can change from person to person, but the elements that go into it basically stay the same. Five variables dictate how credit bureaus create your credit score number.
1) History of paying bills and loans
This is the weightiest component of your credit score. Making payments on time sends a message to creditors that they can trust you to make payments in the future. If you have a history of paying your bills late, creditors will believe you are not trustworthy for future payments as well, regardless of whether circumstances have changed for you.
2) Current debt
The amount of money you currently owe is the second biggest credit score factor. When you have used a significant amount of your available credit, the creditors take this as a sign that you will have trouble making additional payments in the future.
3) Length of credit history
Credit bureaus create their scores by using your payment history. So, it makes sense that a longer history is given more weight. This doesn’t only mean the length of time you have had certain credit accounts open. They also consider what type of account it is and whether you have used it recently.
4) Credit diversity
Having a diverse range of credit lines in your history is seen as a positive by credit bureaus. If you can effectively manage different lines of credit simultaneously, it reflects well on you.
5) New credit lines
Opening new credit lines in a short span of time ups your risk potential to credit bureaus. That doesn’t just mean the number of accounts you have that were created recently. It also means the number of times a lender has inquired about your credit score. It’s important to note that where the inquiry is coming from matters. Inquiries you make into your own credit score don’t have an impact.
Qualify for Better Credit Offers
None of these methods are quick fixes for your credit. Don’t trust people or companies who claim they can remove all negative items on your credit report. Although incorrect items can be deleted from your credit profile, there’s no way you’re removing legitimate items, such as bankruptcy.
The best approach is to check there are no errors in your credit report and to rebuild your credit profile with regular and on-time payments, such as loans or credit card payments. Expect to see improvements in your score after about six months to a year.
If you decide to get a personal loan, stick with lenders that offer competitive rates, consider borrowers with poor credit, and report payments to credit bureaus. Of course, obtaining a loan is not the only or the best way to rebuild your credit score. Consider talking to a credit specialist about your options.
Audrey Henderson is a Chicagoland-based writer and researcher. She holds advanced degrees in sociology and law from Northwestern University. Her writing specialties are sustainable development in the built environment, policy related to arts and popular culture, socially and ecologically responsible travel, civic tech and personal finance.