Do personal loans build credit?

A personal loan can help strengthen your credit, but be aware of the potential drawbacks.

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A personal loan is one way to build credit, but it's not your only option. (Shutterstock)

Taking out a personal loan can help you build credit — if you do a good job repaying the loan. Making monthly payments on time can strengthen your credit score. 

But if you miss payments or pay late, those negative marks can remain on your credit report for years, and may make it tough to qualify for other types of financing, like a car or home loan. 

How you can use a personal loan to build credit

If you find yourself neck-deep in credit card debt, you may want to consider a personal loan for debt consolidation. This type of loan consolidates your current debt load into one loan with one monthly payment, preferably at a lower interest rate and with better terms. 

Personal loan interest rates are generally lower than most credit cards, and you’ll have one predictable payment each month. When you apply, your credit score may take a temporary hit, but if you make all your payments on time, a debt consolidation loan can help build your credit score

Factors that affect your credit score

When considering your application for a personal loan, lenders look at your credit score. But that’s not the only thing they consider. They might also look at your employment history, debt-to-income ratio and whether you have a cosigner or collateral. 

The three major credit bureaus use these five factors to determine your credit score: 

  • Payment history — Your payment history carries the most weight when determining your credit score. If you consistently make on-time payments on your personal loan, your credit score will likely improve over time. But if you make late payments or miss payments, it can hurt your credit and stay on your reports for up to seven years.
  • Amounts owed — When deciding whether to give you a loan, lenders look at how many of your accounts have balances and how much you owe on each. So, paying down or paying off a personal loan can have favorable results on your credit score.
  • Length of credit history — Credit history factors in any new accounts, the age of your oldest accounts and the average age of all your accounts. When you pay off a personal loan, it can remain on your credit report for up to 10 years. During that time, it can continue to help improve your overall score.
  • Credit mix — Having a mix of different types of credit — credit cards and loans — can boost your credit score. If you have credit cards and take out a personal loan, and manage each well, you can improve your credit score over time.
  • New credit — Taking out a personal loan can lower the age of your accounts, but can also boost your credit score by increasing your available credit.

Potential downsides when using a personal loan to build credit

Along with all the benefits of using a personal loan to build credit, you’ll also need to consider the potential risks:

  • Monthly payments — Depending on the rate and terms of the personal loan, you may find yourself stretched beyond your budget just to make your monthly payments. If that happens and you default on your loan, your credit will suffer. Before agreeing to a personal loan, make sure the monthly payment will fit within your budget.
  • High interest rates — For people with good credit, interest rates on personal loans can be much lower than many credit cards. But if you have poor credit or little credit history, you may get higher interest rates, meaning you’ll pay more in interest over the life of the loan.
  • Fees and penalties — Some personal loans come with origination or processing fees, ranging from 1% to 8% of the loan amount, depending on your credit score. Lenders may also charge prepayment penalties for paying off your loan early, so it’s best to review the terms of your personal loan in advance.
  • Can increase your debt load — A personal loan can help pay down or pay off high-interest debt. But if you start racking up more credit card debt as soon as you pay it off, this will increase your debt load and defeat the purpose of taking out a personal loan.

Personal loan alternatives for building credit

If you want to build credit but a personal loan isn’t right for you, consider these alternatives. 

Credit-builder loan

A credit-builder loan is designed for people with no credit or poor credit. A traditional personal loan allows you to borrow money upfront and repay it over time. But with a credit-builder loan, the lender will place the loan amount — usually $300 to $1,000 — into a locked escrow account. 

You’ll make payments in installments, usually over six to 24 months, into a dedicated savings account. Your payments will show up on your credit reports, which can help you build credit over time. And at the end of the loan term, you’ll get the amount in your savings account back, minus any interest and fees.   

Personal line of credit

Personal lines of credit are unsecured revolving credit accounts. Similar to a credit card, you withdraw funds as needed up to a limit. As you withdraw money, your available balance reduces. As you repay the amount you borrow, your available balance is reestablished. 

One disadvantage of personal lines of credit is the potential for a higher interest rate on the amount you borrow than on some credit cards or personal loans. Also, some accounts charge overdraft and annual fees, and there’s always the risk of overspending. 

Home equity loan or line of credit

If you have equity built up in your home, a home equity loan or line of credit can be a good alternative to a personal loan. These loans are secured by your home, so you can often qualify for a lower APR than on a personal loan. Plus, you can use the loan for almost anything. But keep in mind that because your house is used as collateral, if you can’t repay the loan, you risk foreclosure. 

0% intro APR credit card or secured credit card

Although many credit cards come with relatively high interest rates, they may be a good option for building credit if you can find a card that comes with an introductory 0% APR offer for a certain period of time. As long as you pay off your credit card balance before the promotional period ends, you won’t pay any interest on the amount. Just make sure you’re able to pay the balance in full before the promotion ends, otherwise you’ll start accruing interest at the card’s regular rate. 

If you have poor credit, it can be difficult to qualify for a 0% APR card. Instead, you may qualify for a secured credit card that helps you build credit over time. If your credit improves, you may be able to upgrade to an unsecured card. 

Why having good credit is important

If you’ve ever applied for a car loan, rented an apartment or asked to lower the interest rate on your credit card, you understand why having good credit is so important. Besides lower interest rates and better terms, having good credit is essential to your financial future. 

If you need a loan to start a new business, don’t want to pay a large deposit when turning on utilities or want to pay lower insurance rates on an auto policy, a good credit score can create opportunities. Remember that building a good credit score doesn’t happen overnight. It takes time and commitment.