Is taking out a personal loan to build credit a good idea?
Personal loans can be taken out to pay for just about anything. But, will a personal loan build credit, and is it the wisest option for your finances?
March 21, 2022
Your credit score is an important part of your financial well-being. If you have a limited credit history, or no history at all, you may be wondering how to build your credit.
Personal loans are a popular option for building credit. Some people take out a personal loan even if they don’t need it and then pay it off over time to build a positive payment history.
But does a personal loan build credit? And more importantly, are personal loans a good way to help build your credit history? Let’s dive in.
What is a personal loan?
A personal loan is a fixed amount of money that is borrowed and then paid off over time in equal installments.
These loans can be used for anything — emergencies, major purchases, vacations, paying off other debt, etc.
Personal loans charge interest but the interest rate charged can vary significantly. Depending on your credit score, the rate can be as low as 3% or as high as 36%. Nationwide, the average personal loan interest rate is 10.28%.
For example, someone may borrow $5,000 for 3 years. They could use this money to purchase new appliances for their home or to pay for an unexpected expense.
If they were offered an interest rate of 10.28% (the current average), the loan would require payments of around $162 per month for 3 years. The borrower would pay a total of $831.78 in interest over those 3 years, for total repayments of $5,831.78.
Now that we know the basics, let’s move on to the focus of this article: will a personal loan build credit?
Will a personal loan build credit?
If you are approved for a personal loan, and make on-time payments, then the loan can help you build a positive credit history.
Your payment history is a significant factor in determining your credit score. By taking out a loan and making monthly payments, you can build a positive credit history. This shows future lenders that you are responsible with credit and that you pay your bills on time.
But just getting a personal loan won’t help your credit. You need to make sure that you make on-time payments each month. Missing payments, or paying late, can negatively affect your credit score.
Remember, it can take a long time to improve your credit score, so be patient.
Keep in mind that if you have no credit history, it’s unlikely that you’ll get approved for a personal loan.
Are personal loans a good way to build credit?
We’ve established that a personal loan can help you build a positive credit history. But is it a good way to build your credit?
For those who have very limited credit histories, the answer is typically no.
In order to be approved for a personal loan, you’ll need to have decent credit to begin with. And the better your credit, the more favorable terms you will be given.
If you apply for a personal loan with little to no credit history, you may be denied. The same is true if you apply with a poor credit score due to negative marks in the past.
Even if you are approved, you will likely be required to pay a very high-interest rate. The average personal loan interest rate for those with bad credit is 28.5% to 32.0%. Even for those with average credit, interest rates typically range from 17.8% to 19.9%.
Overall, personal loans can be expensive and hard to get approved for. There may be better options for your situation.
One alternative is to take out a small personal loan. Since the loan amount is smaller, you’ll pay less in interest — even if the interest rate is high.
Other useful credit-building alternatives are explored in more detail below.
Alternatives to personal loans for building credit
Personal loans can help you build your credit history, however, they’re not necessarily the best way. Here are some alternatives.
Credit builder loans
Credit builder loans are a type of secured loan. You deposit an amount of money into a locked bank account and then receive a loan for an equal amount. You then pay off the loan in equal installments over time.
The unique thing about credit builder loans is that they don’t require a good credit score, since they are secured by the cash deposit you make. In fact, these loans are specifically designed for those with little to no credit history. Not all banks offer credit builder loans, so check with your local bank or credit union to see your options.
Credit cards are a type of revolving credit. If approved for a credit card, you will be given a credit limit. You can then spend up to that limit, and either pay off the card immediately, or carry a balance and pay it off over time. Carrying a balance will result in interest charges, while paying the card off in full each month won’t cost you anything in interest.
Credit cards do require decent credit to be approved for, and their interest rates are typically high. But again, if you pay off the card in full each month, credit cards can be a good way to build credit with no interest costs at all.
Secured credit cards
A secured credit card is similar to a credit builder loan, in that you must deposit a certain amount of money into a bank account that you cannot access. You will then be given a credit card with a limit that equals however much you deposited into the bank account.
The advantage of secured cards is that they don’t require much credit history to get approved for. This makes secured cards a good option for early credit building.
Existing credit accounts
If you already have a loan or credit account open, you can build credit history by continuing to make on-time payments each month.
This doesn’t mean that you need to rack up credit card debt. In fact, carrying a balance on your credit card won’t help your credit score. You should aim to pay off your credit card in full each month to avoid interest charges. As long as you make on-time payments, this will still help improve your credit.
Do you have existing credit card debt to tackle? Tally† may be able to help. Tally helps qualifying Americans pay off their credit card debt faster by consolidating to a lower interest rate line of credit.
†To get the benefits of a Tally line of credit, you must qualify for and accept a Tally line of credit. Based on your credit history, the APR (which is the same as your interest rate) will be between 7.90% - 29.99% per year. The APR will vary with the market based on the Prime Rate. Annual fees range from $0 - $300.