Credit Sesame discusses how to use a personal loan for credit building.
Using a personal loan for credit building is one way to show a consistent payment history that can lead to good credit scores. Credit builder loans can help you do this even if you have a bad credit history or haven’t yet established credit. There are potential pros and cons to using credit builder loans.
How personal loans help you build credit
Your payment history is the biggest single factor in determining a credit score. You need some record of making payments to establish a credit score. If you consistently make payments on time, it will help your credit score. If you often miss or are late with payments, your score will be dragged down.
Personal loans help build credit because they typically give you a regular monthly schedule with a fixed payment every month. That makes it easy to budget for and manage your payments. When you sign up for a personal loan, you can see exactly how long it will take to pay off the loan and how much it will cost.
Personal loans also help build credit because they are a form of installment debt. That means they have regular, recurring payments. Installment debt differs from revolving credit, which allows you to tap into a line of credit regularly. Most loans are installment debt, while credit cards and home equity lines of credit are examples of revolving credit.
To build credit, it’s best to have a mix of installment and revolving debt. So, if you don’t have any other loans, a personal loan can help you show you can handle installment debt.
How to get a personal loan with bad credit
Of course, the classic problem with establishing or improving bad credit is that it can be hard to get credit unless you have a good credit history. This is where credit builder loans can help.
Credit builder loans are a type of personal loan designed to reduce the lender’s risk and be available to people without a strong credit record.
Not all lenders offer credit builder loans. However, if you search online for them, you should find several options. You can also check with your local community banks or credit unions to see if any of them offer them.
How credit builder loans work
Credit builder loans are different from other loans because the amount you borrow isn’t immediately available for you to use. Instead, the lender will put it in a savings account or certificate deposit on your behalf.
The money in that account is used as collateral for the loan. Lenders are confident in making credit builder loans to people who don’t have great credit because they know the loan proceeds are kept in a secure account.
As with most other loans, you make set payments on a regular schedule – typically over a period of 6 months to 2 years. Part of these payments goes to paying back what you borrowed, and part goes towards paying interest on the loan.
When you’ve repaid the loan, the money put in the secure bank account will be available to you. Meanwhile, the lender will have reported your payments to one or more of the three major credit bureaus. If you’ve made those payments on time, this should help your credit score.
Benefits of credit builder loans
People often feel shut out from credit because no one will give them a chance to prove they can be relied on to make their payments. Credit builder loans can overcome this problem because you don’t need excellent credit to get one.
So, credit builder loans can help you establish credit for the first time. Credit builder loans can also help improve a poor credit score. In other words, they allow people to use a personal loan to build credit even if they don’t have a strong credit history.
Potential drawbacks of credit builder loans
One problem with credit builder loans is that you are paying interest to borrow money without actually getting the use of that money. The proceeds from the loan are not available to you until you’ve made payments on it. It would be more cost-effective to simply put the amount of those payments into a savings account yourself. That way, you’d be earning interest rather than paying it.
Also, the Consumer Financial Protection Bureau (CFPB) found that getting a credit builder loan can make it harder to keep up with other payments. Missing payments on other debts would negate the benefits of making payments on the credit builder loan.
Making a credit builder loan work for you
Here are some tips for successfully using a personal loan for credit building:
- Budget to make all your payments on time. This includes the credit builder loan payments and any other payments you owe. The CFPB found that credit builder loans were most effective in establishing credit and improving scores for people who didn’t have other debts.
- Check who the lender reports payments to. There are three major credit bureaus – Equifax, Experian and TransUnion. To help you build a payment history, the lender must report to at least one of these. Your payment history is most impacted if the lender reports to all three credit bureaus.
As with all credit, you are judged on your payment history. So, it’s vital to establish a positive history.
Alternatives to using a personal loan for credit building
Besides using a personal loan for credit building, there are some alternatives to consider. A secured credit card is another way to establish credit without a strong credit history. As with a credit builder loan, it requires you to commit some money as collateral to build credit. Again, revolving credit and installment loans are two different things, so it’s best to establish a track record with both types of credit.
Loans such as car loans that use a physical asset as collateral are often available to people with less-than-perfect credit. These offer an opportunity to build credit if you can afford the terms. Student loans can also provide an opportunity to establish a credit history.
Whether you use a credit builder loan or another method, getting the chance to build a track record of using credit is just the first step. In the long run, it’s how good a track record you establish that will make the most difference.
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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.
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