Can Personal Loans Help Your Credit?
A personal loan can help your credit, but whether it's the right way to go depends on how you use it.
Image source: Getty Images.
A personal loan can improve your credit score in more ways than one. Most personal loan companies report your balance and payment activity to all three credit bureaus (Experian, Equifax, and TransUnion), which can help you build good credit over time. Personal loans can also be used to consolidate other high-interest debt, which helps you save money and quickly improve your credit score.
How much a personal loan can raise your credit score depends on your circumstances. Below, we'll look at how a personal loan can help if you have high balances on other loans, have bad credit history, or if you have no credit history at all.
If you have high-interest balances to consolidate
Having high balances on credit cards, or other high-interest obligations, will hurt not only your credit score, but also your wallet. If you're in this situation, then getting a personal loan is often a great idea, because it can help you save money in interest and improve your credit score almost overnight.
Your credit utilization ratio -- that is, the percentage of your available credit that you're currently using -- makes up 30% of your credit score, making it the second-most important factor in calculating your score (paying your bills on time is the most important).
Here's how people slip up in managing their balances:
- Carrying a high balance on credit cards. Contrary to popular belief, credit bureaus don't look at your balances on an absolute basis. In other words, the dollar amount of your balance isn't what really matters; having a $500 balance isn't necessarily better than having a $1,000 balance. Instead, they look at your balances as a percentage of your credit limits, i.e., your credit utilization ratio. Ideally, your balance shouldn't be higher than 30% of your credit limit. So if you have a $3,000 credit limit, that means you should keep your balance at $900 or less.
- Carrying balances on several different accounts. Nothing sounds alarm bells like having balances on multiple credit accounts. It can indicate that you're financially stretched, unable to pay off even the smallest balances in full. For this reason, having a $1,000 balance on one of five credit accounts is almost always better than having a $1,000 balance split between five different accounts.
A personal loan can fix both problems. Using a personal loan to pay off credit card debt will reduce your credit utilization ratio on your cards, which helps your credit score. The impact is even greater when you consolidate debt on several accounts to one personal loan, as this reduces the number of accounts on which you have a balance. Fixing a credit utilization problem is one of the fastest ways to improve your credit score.
To show you how this works, let's say you have three different credit cards, two of which have a high balance as a percentage of your credit limit. Your credit report might show three accounts that look a little like this:
Source: Author.
In this scenario, you're getting hit hard from all angles. Your overall utilization ratio is extremely high at 78% of your available credit. And on an individual basis, two of your cards are well above the 30% utilization threshold that is often quoted as a good number to stay under.
Getting a personal loan to consolidate and pay off your debt can make a big difference. Here's what your credit report would show after you used a personal loan to pay off your credit cards.
Source: Author.
The personal loan helps all around. It increases your total credit limit, which reduces your overall credit utilization ratio. It also eliminates three of your balances, which reduces the utilization ratio for each of those accounts. With every payment on your personal loan, the balance will decline, too, so it only gets better from here.
Best of all, consolidating your debt will save you money in addition to helping your credit score. Credit card balances typically carry an annual percentage rate (APR) of 18%, if not more. In contrast, personal loans can have interest rates as low as 6%.
You have bad credit history you want to fix
Having late payments and accounts in collections can tank your credit score, and these accounts can stick around on your credit report for seven years. The good news is that they become less important over time and eventually fall off your credit report completely. As a rule, as information on your report ages, it has less of an impact on your credit score.
If you have old accounts that are weighing down your credit report, the best way to start fixing your report is to beg for forgiveness. Beyond that, a new account in good standing can help to mitigate the bad marks on your credit report.
While a personal loan can act as a "good' account on your credit report, you'll pay a steep price for the loan if you have bad credit. If you have bad credit, you might pay an APR as high as 20% or more on a two-year personal loan. So if you borrowed $1,000, you'd end up paying about $222 in interest over the life of the loan. That's a high price to pay to put a good account on your credit report.
Source: Author.
A better way to paper over bad history with good accounts is to open a secured credit card. A secured credit card works like any other credit card with one major exception: Getting one requires that you put down a deposit as collateral. The best secured cards have deposit requirements ranging from $49 up to $200. In exchange, you'll get a card with a limit equal to your deposit. If you want a higher limit and you don't mind tying up your money, you can deposit $1,000 or more up front.
The deposit protects the lender in the event you fail to pay what you owe, and that protection enables lenders to issue secured credit cards to nearly all applicants. Secured cards are essentially designed for people who have bad credit -- applicants who would be denied for other cards.
A secured card will report to the credit bureaus like any other credit card or personal loan, so it's important to make payments on time. Secured cards also charge interest when you carry a balance, so you'll want to pay in full each month to avoid paying any interest.
That said, if you open a secured card account, use it wisely, and always pay on time and in full, it will help you rebuild your credit, and you won't pay a dime in interest to do it. Plus, with several months of on-time payments, your can ask your credit card issuer to "graduate" your card to an unsecured card, at which point the card issuer will send your deposit back to you.
When used wisely, a secured credit card is a truly free way to rebuild your credit. Plus, getting one is much easier than getting an unsecured personal loan. (So long as you can foot the deposit, even bankruptcy isn't enough to stand in the way of an approval.)
You want to start building credit history
Personal loans almost always report to the three credit bureaus, which can help you establish credit or pad a thin credit report with more data points showing your creditworthiness. Many smaller banks and credit unions have promoted personal loans as a tool for building credit, offering small "credit builder loans" to people who want to borrow money for the explicit purpose of building credit history.
I'm here to tell you that if your only goal is building credit, a personal loan isn't the way to go.
First, a personal loan will cost you money in interest and fees. It never makes sense to spend money just to build up your credit report. Secondly, a personal loan will eventually fall off your credit report after it is completely paid off, so the benefit you get from one is temporary.
If your goal is to build credit history, a no-annual-fee credit card is a better way to do so, because it doesn't have any of the drawbacks of a personal loan. First, if you always pay your balance on time and in full, you won't pay anything in fees or interest. Secondly, a credit card can be kept open indefinitely, meaning you could keep the same account open and reporting to the credit bureaus from your 18th birthday to your 98th birthday.
I'm living proof. The bedrock of my credit report is a no-annual-fee credit card I opened more than a decade ago. I plan to keep this account open forever, because having a 10-plus year old account with perfect payment history is doing wonders for my credit score.
If I had started building credit with a personal loan, it would have disappeared from my credit report several years ago. But this credit card is still there and still reporting. With each passing month, it adds another month of age to my credit. I use it a few times per year for a small purchase to keep it open, and other than that, it takes no effort, costs me nothing, and helps me keep my credit score above 800.
You could quite literally open a no-annual-fee credit card, use it for nothing more than a Netflix subscription, and end up with an excellent credit score forever -- seriously!
The bottom line on using personal loans to help your credit
Personal loans make the most sense when they offer more than just a credit score boost. For example, paying off credit cards with a personal loan can help your credit, but it can also help you save money on interest. You're getting something more than just credit score help: You're saving real money by reducing the interest you pay.
In contrast, getting a personal loan just to help you build or rebuild credit rarely makes sense. For people with bad credit or no credit at all, no-annual-fee secured credit cards and starter unsecured credit cards are a no-brainer solution because they can be easier to qualify for, and they're free so long as you always pay on time and in full.