How to Build Credit With a Personal Loan

A personal loan can effectively build your credit by establishing a positive payment history, which accounts for 35% of your FICO score. When you take out a personal loan and make your payments on time, each installment is reported to the three major credit bureaus — Experian, TransUnion and Equifax. Making regular and timely payments demonstrates your reliability as a borrower to lenders and future credit providers. Over time, this can lead to improvements in your credit score, opening up opportunities for more favorable loan terms and lower interest rates.

To build a positive payment history, set up automatic payments to avoid missing due dates, keep track of your financial commitments and always aim to pay more than the minimum due whenever possible.

Adding a personal loan to your financial portfolio introduces a type of installment credit, different from revolving credit like credit cards. This variety in your credit types shows you can handle different kinds of credit responsibly. As you make regular payments on the personal loan, you not only strengthen your payment history but also enrich your credit mix, which makes up 10% of your FICO score.

Lenders and credit bureaus see this diversity as an indicator of a well-rounded borrower capable of managing multiple credit formats effectively. For better results, maintain this balance by managing all credit types wisely and keeping your revolving credit balances low relative to your credit limits.

Credit utilization, which accounts for 30% of your FICO score, measures the amount of your available credit you are using, particularly with revolving credit such as credit cards. For example, if you have a $25,000 limit on your credit card and use $3,000, your credit utilization ratio is 12%. Generally, a lower utilization rate is viewed favorably.

By using a personal loan to consolidate credit card debt, you decrease the balances on your revolving accounts, lowering your utilization ratio. This reduction can positively impact your credit score as it indicates to lenders that you are not overly reliant on credit and manage your debt responsibly. To optimize this benefit, continue to keep your revolving credit balances low after paying them down with a personal loan.

The length of your credit history makes up 10% of your FICO score and includes the ages of your oldest and newest credit accounts and the average age of all your accounts. If you have little to no credit history, lenders might be cautious about offering you money because they have less evidence of your ability to manage and repay debt.

Taking out a personal loan and responsibly managing it adds a new dimension to your credit report. This loan becomes part of your credit history, gradually lengthening it as you continue to make timely payments. This can prove to lenders that you are capable of handling long-term financial commitments.

When you apply for a personal loan, lenders perform a hard credit inquiry to assess your creditworthiness. This can lower your credit score by up to five points. Although this decrease is relatively small and the impact lessens over time, it can add up if you make several loan applications close together.

To minimize the negative impact of hard inquiries, limit the number of personal loan applications you submit within a short period. Instead, research potential lenders thoroughly and choose the one that best suits your needs before applying.

When you borrow money, the amount you owe becomes a significant factor in calculating your credit utilization ratio, particularly if the loan is a substantial sum. A higher debt level can signal to lenders that you might be a higher-risk borrower because it suggests a greater dependency on borrowed money. This perception can be especially impactful if your existing debt is already high relative to your income.

To manage this risk, evaluate your financial situation and determine whether a personal loan offers more benefits or drawbacks. If you need to pursue an application, ensure that you borrow only what you need and have a solid repayment plan in place.

Taking out a personal loan often involves fees like origination fees, late fees and prepayment penalties. These can increase the overall cost of borrowing and potentially reduce the amount you actually receive.

Say you take a $10,000 loan with a 5% origination fee. This fee reduces the actual amount you receive to $9,500, but you are still responsible for repaying the full $10,000.

To avoid any surprises, always read the fine print and understand all the fees associated with a personal loan before agreeing to the terms. Make sure you can comfortably afford the loan with its associated costs, and aim to make your loan payments on time to avoid any fees that might come from late payments.

Building up your credit doesn’t happen overnight. It’s a process that takes time and a responsible history of credit. The exact timeline can vary based on each person’s situation, but here’s a general timeline:

1. Once you’ve been approved for a personal loan, the lender will typically report the loan to the credit bureaus within 30 to 60 days. This is when the loan first appears on your credit report.
2. Over the next few months, as you begin making on-time payments on your loan, you’re establishing a positive payment history.
3. After about six months to a year of consistent on-time payments, you should start to see a positive impact on your credit score.
4. In the long term, continuing to make on-time payments on your personal loan (and all other debts) will continue to positively impact your credit score. — Alvin Yam, CFP