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How Personal Loans Build Credit?

A personal loan can help to build credit if you follow 3 simple rules. How does it work, is it a smart move, and how fast do you build credit?
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
Interest Rates Last Update: April 15, 2024
The banking product interest rates, including savings, CDs, and money market, are accurate as of this date.
Author: Baruch Mann (Silvermann)
Baruch Mann (Silvermann)

Writer, Contributor

Experience

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
Interest Rates Last Update: April 15, 2024

The banking product interest rates, including savings, CDs, and money market, are accurate as of this date.

You can trust the integrity of our unbiased, independent editorial staff. We may, however, receive compensation from the issuers of some products mentioned in this article. Transparency is a core value for us, see how we make money.

Table Of Content

Do Personal Loans Build Credit?

Personal loans impact four aspects of your credit history: on-time payments, credit utilization, a mix of account types, and credit inquiries.

Therefore, a personal loan can build and improve your credit score if you do it smartly. It can take a couple of weeks to even a year to see the impact on your score.

1. Make On-Time Payments

The on-time payment section of your credit report is simply a percentage of how many on-time payments you have made.

If your on-time payment rating is less than perfect, adding a personal loan to the mix does offer you the chance to improve your percentage by making on-time payments with a new personal loan.

2. Manage Credit Utilization Rate

Credit utilization rate measures how much of a balance you currently have across all of your credit cards. This aspect of your credit score takes into account solely the amount on credit cards, so the balance due on a loan is not factored in.

A common type of personal loan is a debt consolidation loan, often used to obtain money to pay off credit card debt. Paying off credit card debt with a loan means that the money you owe would not be part of a credit card balance, lowering your credit utilization rate.

This is one of the chief advantages of taking out a personal loan to pay off credit card debt which is one of the most common uses of personal loans.

This chart created with Experian data shows that those with an average to good credit score have an average credit utilization ratio of the optimum 33%. This ratio drops significantly for those with very good and excellent scores.

At the other end of the scale, the chart shows that those with poor credit scores typically have a very high credit utilization ratio, with an average of 73%. This will be a massive factor in lending decisions for those in this group.

 

3. Improve Your Mix of Account Types

Credit scores calculate the risk of lending money to you and are considered one of the common requirements to get a new loan. A person with a history of making reliable payments on several accounts is deemed less risky than someone with a history of making reliable payments on a limited number of accounts.

If you currently have only a small number of credit cards and loans, for example, just 1 or 2, then adding a personal loan will increase the number of open accounts you have, which would benefit your score.

Additionally, if you only have credit cards but no loans, adding a loan to your mix would add to the variety of account types. This is an important factor and would boost your score in this aspect.

4. Establish a Credit History

The length of your credit history has three components-

  • Age of oldest account
  • Age of newest account
  • The average age of open accounts

By applying for a new personal loan, will bring down your average age of accounts and reset the age of your newest account. Because of this, obtaining a new personal loan will hurt this area of your credit report.

Depending on the other factors on your credit report, this may cause a dip of a few points in your score, or the dip could be outweighed by other factors that are impacted when you obtain the loan.

5. Use Soft Pull Credit Inquiries

Any time there is a hard pull on your credit report, it will negatively influence your credit score.

The effect of these hard pulls will wane over time, but within the first few months after your applied for the loan, this part of your credit report will have a negative effect on your overall score.

Should I Get a Personal Loan to Build Credit?

Personal loans can benefit your credit if the following are true for your situation. On the other side, they are not always the right tool for every situation.

When Does It Make Sense
When Doesn't It Make Sense
You need the money from a personal loan
If you're not sure you can pay it off
You wish to add a mix to your credit score
Planning a mortgage or car loan soon
You can reliably make all payments
Recently applied for other loans

A personal loan should not be taken out with the sole purpose of improving your credit score. 

If you do need the funds, taking out a personal loan can be a good option that will have the added benefit of impacting your credit score.

The mix of accounts you have open does impact your credit score. If you only have credit cards open and no loans, adding a personal loan to your credit score would benefit this aspect of your credit report.

A personal loan will only benefit your credit score if all of the payments are made on time. Even one late payment can damage your credit score.

If you cannot afford the payments or are afraid you can't pay your personal loan back, a personal loan would not help you to build credit.

The benefits of having the loan added to your mix of account types would not be as great as the damage caused by late or missed payments.

If you are planning to apply for another loan soon, such as a car loan or mortgage- A hard credit pull is required for most personal loan applications.

Once a hard pull inquiry is performed, many lenders will hesitate to approve you for another loan within six months.

Additionally, one of the cons of a personal loan is that taking out a personal loan will lower the average age of your open accounts, which could also negatively impact your credit score in the short term.

If you have recently applied for other loans or credit cards, it is not a good idea to immediately apply for a personal loan because your approval chances will be lower.

How Fast Does a Loan Build Credit?

Once approved for a personal loan, it will be reported to the credit bureaus within the month. You can expect to see an improvement within 3-6 months and a significant effect after 12 months.

Personal loans are generally reported to the credit bureau every month just like credit card statements and other types of loans.

As discussed above, the way obtaining a new personal loan will impact your credit score varies based on a number of factors-

  •  Payments History – This is one of the most heavily weighed factors on your credit report. If you have been consistently making on-time payments on your other accounts, opening a new personal loan will not be able to improve your score in this regard.

But, if your credit score has been damaged by payments that were not made on time, making on-time payments on a personal loan will improve this aspect as soon as each payment is made.

  • Age of other accounts- Adding a new loan to the mix will decrease the average age of your accounts. A new loan will significantly drag down your average account age if you have only one or two credit cards or loans.

This will impact your credit report immediately, and as the age of the personal loan grows it will become less of a drag on this section of your credit report.

  • Your existing mix of accounts- If you currently only have credit cards open, your score will immediately boost your score in this section. Adding a loan to the mix will increase your blend of credit accounts and show lenders that you are capable of managing different types of payments.

How Personal Loans Can Ruin Your Credit

Personal loans are a double-edged sword that can cut your credit score both ways. There are a number of various benefits to your credit score, but there are risks to your credit score as well. A combination of factors will determine the outcome.

Here are some keep tips to avoid mistakes and prevent a personal loan from ruining your credit.

Whether or not your loan and credit card payments are made on time is one of the most important factors in determining your credit score. One of the benefits of personal loans is that most are a type of installment loan.

This means that the payment amount will be the same each payment cycle, which may make it easier to incorporate into your monthly budget.

If you are not sure whether or not you will be able to make all payment on time, consider other options to achieve your financial goals other than taking out a personal loan.

 Any hard inquiry on your credit report will negatively impact your credit score. This is because banks and other financial companies view people who seek out a lot of credit in a short amount of time as riskier to lend to. 

This could also hurt you if you are planning to apply for another type of loan in the near future such as a mortgage or a car loan. If you have a recent credit pull from taking out a personal loan, you may get a worse interest rate or be rejected for the other types of loans you may need.

Taking on debt that is beyond your means can negatively affect you in a number of ways.

For example, if in order to afford your personal loan payments you are unable to pay off the balance on your credit cards, that will lead to a higher credit utilization rate which will do damage to your credit score.

Alternatives to Build Credit

Personal loans are not the only options available for building credit. Though can be a  power tool for knocking your credit score up to the next level, consider the following alternatives

  • Pay off your credit card balance as much as you can. A low credit card utilization rate is one of the most important things for improving your credit score. You can read about the best ways to pay off a credit card debt.

Even if you are paying the balance in full each month, consider paying it twice a month so that when your balance is reported to the credit bureau, it’s fully or mostly paid off before the end of your billing cycle.

  • Apply for a higher credit limit on a current credit card. Gaining a higher credit limit on a credit card you already have can both give you additional credit to spend, and bring your credit utilization rate down.

Additionally, increasing your credit limit on a current card will not affect the length of credit history portion of your credit report, because it will not alter the average age of your accounts nor the age of your newest account. Depending on your bank, obtaining a higher credit limit may or may not result in a hard pull of your credit.

  • Take out a credit-building loan if your main reason for seeking a loan is to build credit. Credit building loans are similar to savings accounts and have the key benefit of not creating debt for you. With a credit building loan, you make payments each month which are reported to the credit bureau.

In the end, you generally receive all of the money you had paid. Credit building loans are especially effective if you do not have a long credit history, need to improve your payment history, and if you have no need to receive the funds from a loan at the moment.

FAQs

Paying off a personal loan can actually harm your credit score because it takes away the payment history that you gained through having the loan.

When a personal loan is paid off, it also reduces your credit mix, because having a mix of different account types is a factor used to calculate your score.

A personal loan can build your credit by adding to your mix of accounts. If you make payments on time it can also contribute to your on-time payment ratio.

Additionally, borrowing money with a personal loan can lower your credit utilization rate if by taking out the loan you having less money taken out on your credit card.

Both personal loans and credit cards can help you to build credit. The important thing is having a mix of different accounts in your lending history. The ideal credit mix would contain a combination of credit cards and loans.

A personal loan is a way to get money that you wish to spend. A credit builder loan is a loan taken out solely to build credit. Credit builder loans do not give the lender the money up front.

Instead, the lender makes monthly payments solely to report on their credit report that they are making payments.

Unsecured personal loans do not require collateral, but cash-secured loans do. Taking out a loan without collateral will generally require better credit in order to get approved, and it may come with a higher interest rate as well.

Your savings, home, investing accounts and even jewelry can be used as personal loan collateral.

Picture of Baruch Mann (Silvermann)

Baruch Mann (Silvermann)

Baruch Silvermann is a financial expert, experienced analyst, and founder of The Smart Investor.  Silvermann has contributed to Yahoo Finance and cited as an authoritative source in financial outlets like Forbes, Business Insider, CNBC Select, CNET, Bankrate, Fox Business, The Street, and more.
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