Do Personal Loans Build Credit? Only If You Use Them This Way

Personal loans can help you build credit, but only if you manage them the right way.

There's a whole lot of upside to opening a personal loan to help you build credit. But if you abuse your new account, your credit will trend the other way — in a hurry. Here's what you need to know.

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How Personal Loans Show Up on Your Credit Report

When you open a personal loan, the account is reported to the major credit reporting agencies — namely, Experian, Equifax and TransUnion.

Instead of a revolving line of credit line that you can continually use, pay off and use again — like a credit card or a home equity line of credit, these appear as installment loans.

In other words, they're loans that you pay down monthly until they are completely paid off. Some examples:

• Student loans

• Auto loans

• Mortgages

3 Ways a Personal Loan Can Help Your Credit

A personal loan can help your credit by giving you an opportunity to demonstrate healthy credit habits to the credit bureaus — and by extension, to lenders. Here's how:

1. On-Time Payments Show You're a Responsible Borrower

Financial institutions examine your credit profile before approving you for a loan, and they want to see responsible credit habits. Always making on-time payments can improve your credit considerably.

2. Your Credit Mix Gets Diversified

Opening a personal loan can also boost your "credit mix," an important factor that makes up your credit score. FICO awards you for having different account types, such as a credit card, an auto loan and a personal loan.

3. Reduces How Much Credit You're Using

A personal loan can also lower your credit utilization if you're requesting money to pay down high-interest credit card debt. Credit utilization is one of the weightiest components that make up your credit score. Once you reduce the balances on your credit card, your credit score could catapult within a month or two.

How a Personal Loan Can Hurt Your Credit

A personal loan may initially hurt your credit — but don't panic. This short-term dip is due to the hard credit inquiry your credit report sustained when you applied for the loan. Use your new account responsibly, and your score will likely be back and better than ever within a few months.

Beyond the initial temporary ding, a personal loan can hurt your credit in more severe ways depending on how you use it.

• Miss a payment, and your credit score can carry that blemish for up to seven years.

• Opening a personal loans can also trick you into thinking you can spend more than your budget allows, which can lead to increased debt and high interest payments if you're not careful.

• Finally, a personal loan may cause your credit to dip slightly when you inevitably pay off the loan and close the account.

What's the Required Credit Score for a Personal Loan?

You'll need at least a "fair" credit score, defined by FICO as 580 or above to be approved for most personal loans. Some lenders offer personal loans for those with subprime credit, but the terms are often less favorable.

If Your Credit Score Is Less Than 580

A score in the high-500s or low-600s may earn you an approval, but your interest rates are sure to be through the roof. Your credit score signals your creditworthiness to lenders. The more creditworthy you are, the more favorable APR you'll usually get.

Your best bet is to wait until you've got at least a 670 credit score, which considered "good" according to FICO.

Remember that your credit score isn't the only thing lenders care about. They may look at details like your debt-to-income ratio, your employment history or the amount of new accounts you've opened recently.

Does Paying Off a Personal Loan Help Your Credit?

There are pros and cons of a personal loan when it comes to building credit. It's a bit of a two-edged sword.

Paying off your personal loan shows other lenders that you faithfully pay back the money you owe. However, after you make your last payment, your loan will be closed. This can lead to a ding on your credit score, because it will lower the average length of your credit history — another important factor in making up your credit score.

Still, it's only a downside in the short term. Your positive payment history will benefit your credit in the long run.

When a Personal Loan Makes Sense for Building Credit

Typically, opening a personal loan and making payments on it doesn't make a lot of sense for the sole purpose of building credit. That's because installment loans incur monthly interest payments — meaning you're effectively paying for the privilege of building credit. There are less expensive ways to do this, such as opening a credit card.

If you've actually got a need for a personal loan, it's a great way to boost your credit mix and increase your positive payment history. Just make sure you've got the ability to make the monthly payments.

When a Personal Loan Might Not Be the Right Move

If you've got a poor credit score, the best loans with the most reasonable APR will be out of your reach.

Also, those already struggling to make monthly payments on the bills they currently have shouldn't open a new loan — unless it's to consolidate current bills.

How a Personal Loan Impacts Your Credit Score

FAQs

Do personal loans hurt your credit at first?

Personal loans do hurt your credit at first. That's because the lender will perform a hard credit inquiry on your credit report — which lowers your score by a few points temporarily. Don't worry — the drop doesn't last for long.

How fast can a personal loan improve my credit score?

It depends on the state of your credit profile. A personal loan can improve your credit score in 30 days if you use it to pay off your high-balance credit cards and consolidate your debt. If you've got a messy credit history, though, it could take a year or more to make real change.

Can I get a personal loan with bad credit?

You can get select personal loans with bad credit thanks to credit builder loans, like the Self Credit Builder account. Loans like these don't drop a large chunk of cash into your bank account. Instead, Self deposits money into a CD, which you pay off in monthly installments.

Will my score drop after I pay off a loan?

Your score may drop after you pay off a loan because your average length of account history will decrease, but this effect is usually minor and short-lived.

What credit score do I need for a personal loan?

Most personal loans require at least "fair" credit, which is 580 or above. To have access to nearly any loan you want, wait until your credit score is at least 670.

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