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If you’re working to build or rebuild your credit history, you may want to think twice about using a personal loan to do it.
While plenty of lenders may be willing to work with your credit situation, you may have a hard time finding favorable terms. And if you’re not careful, you may find that the lender isn’t helping you build credit at all.
Here’s what you need to know about getting a personal loan to build credit, along with ideas for other ways to help strengthen your credit profile.
- How you can use a personal loan to build credit
- Why you should think twice before using a personal loan to build credit
- Personal loan alternatives for building credit
How you can use a personal loan to build credit
A personal loan may help with most of the five factors that influence your credit scores.
- Payment history: Getting a loan and making all of your monthly payments on time establishes a track record of responsibility. This is a primary factor in building a positive credit profile.
- Credit usage: How much debt you have — and what kind — is a reflection of how well you manage credit. Having a personal loan can help with this, as long as you pay it back according to the terms and don’t pile up too much other debt.
- Length of credit history: A longer credit history can show you being responsible with credit over time, strengthening your credit profile. If you’ve never used credit, getting a personal loan can help you start this process.
- Credit mix and types: If your credit history is limited, having varying types of credit, like credit cards, personal loans and mortgages, can help boost your credit scores.
The fifth factor that can influence your credit profile is recent credit. When you apply for a personal loan — or any type of new credit for that matter — the lender may run a hard inquiry on your credit reports to check your credit history. This can lower your scores by a few points. That said, a single inquiry typically won’t influence your scores significantly, and they can often recover within a few months.Hard and soft credit inquiries: What they are and why they matter
Why you should think twice before using a personal loan to build credit
Using a personal loan responsibly may be able to help you build credit, but it may not be the best option for everyone — and there are ways that a personal loan can also hurt your credit.
Late payments will hurt your credit
As with any form of credit, one obvious risk with personal loans is that payments 30 days late or more typically show up on your credit reports — and that can lower your credit scores.
“If for some reason you can’t repay the loan, the lender will absolutely report your delinquency or your default to the credit bureaus,” says James Garvey, CEO of Self Financial, an online company that offers credit-builder loans.
Bad-credit and no-credit personal loans are expensive
Having less-than-stellar credit may not stop you from getting approved with certain lenders, but there’s usually a price to pay when you’re considered a higher-risk borrower. Some personal loans come with an annual percentage rate of more than 30%, while fees associated with payday loans translate to triple-digit APRs.
APRs can include both interest and fees, so it’s important to read the fine print to know what you’re paying.
Short-term loans can be dangerous
While some personal loans give you years to pay back what you owe, some small loans, including payday loans, may give you as little as a week or two and require a single payment.
If you can’t afford to pay the loan back in time, you may be forced to renew it or take out another one to make the payment, which can throw you into a vicious cycle of debt.
Not all personal lenders report to the major credit bureaus
Trying to use a personal loan to build credit? Imagine finding out that your activity isn’t being reported to any of the three major consumer credit bureaus.
Unfortunately, that’s the case with some personal loans. If you’re not careful, you could spend months or even years making on-time payments without it being reflected on your credit reports.
Personal loan alternatives for building credit
If you want to build credit but your personal loan options come with sky-high APRs or other unfavorable terms, it may be worth considering a credit-builder loan or a credit card — or simply continuing to use your current credit accounts responsibly.
Here’s what you need to know about each option.
A credit-builder loan is specially designed to help borrowers build credit. Instead of giving you the loan amount, which is usually between $300 and $1,000, the lender, typically a credit union or online lender, deposits the sum into a locked savings account.
You’ll then make monthly payments over the next six months to two years, which the lender will report to the three consumer credit bureaus. Once the loan term is over, you’ll receive the loan amount plus any interest it accumulated in the savings account.
While interest rates can vary by credit union, your APR at a federal credit union has a cap of 18%. However, payday alternative loans, which are short-term loans offered by some federal credit unions, have a cap of 28%.
If you’ve never had problems using credit cards in the past, it may be worth getting one now to build or rebuild your credit history. Depending on your situation, though, you may have a limited selection.
If you have no credit or a limited credit history, for instance, you may qualify for an unsecured credit card, or a student credit card if you’re in school. You can compare student credit card offers on Credit Karma to learn more.
If you don’t qualify for either of those options, you may be able to get a secured credit card. These cards require a security deposit as collateral, but some cards allow you to eventually get that deposit back and convert to an unsecured card.
While these cards may charge high interest rates, you can avoid the cost altogether if you pay your bill in full each month by your due date.
If you don’t want to apply for a credit card on your own, Garvey recommends trying to get added as an authorized user on a family member or friend’s credit card account. That way, their activity with the account may also show up on your credit reports and can help boost your credit scores.
Your current credit accounts
If you already have an open credit card account or loan, you may not need a new one to work on improving your credit. As long as the lender reports your account activity to the three major consumer credit bureaus, using it regularly and making your monthly payments on time can help you build credit.
“Your success in building credit with any of these options will depend very much on whether you can use them responsibly,” Garvey says.
It’s possible to use a personal loan to build credit. But if that means high fees and interest, too-short repayment terms or lenders that don’t report credit activity, it may be worth considering some alternatives instead.
With credit-builder loans and credit cards, you may be able to pay less while accomplishing the same goal.