Taking out any form of credit, including a personal loan, will be recorded on your credit report and could impact your credit score.
However, provided you make your repayments on time and settle your debt as agreed, this might not be a bad thing. In fact, a personal loan can actually help you build credit if you can prove you’re a reliable customer.
In this guide, we’ll go into a bit more detail on how a personal loan can help you build credit.
The relationship between personal loans and your credit file
Your credit report (also known as your credit file), provides a detailed overview of your financial history. It includes information about the finance products you have, your total amount of current debt and whether you make your repayments on time.
Lenders like us can request access to your credit report when you apply for a finance product. This helps lenders make a decision on your application, as they can see what kind of customer you’re likely to be. Those who are predicted to be good customers are more likely to be accepted, and offered better rates, compared to applicants who have a poor credit history.
We’ve already stated that applying for a loan can affect your credit score. That’s because taking out any form of credit – including a personal loan – will be recorded on your credit file. This will, in turn, make a difference to your credit score as a lender’s scoring system will assess the information found in your credit report.
How does a personal loan build credit?
If your application is accepted and you take out a personal loan, there are three main reasons this can have a positive effect on your credit history:
1. Strong payment history shows you can handle debt responsibly
Lenders like to a see you pay back what you owe on time, consistently. A personal loan can be a big financial commitment but if you prove you can keep on top of your repayments this could help to improve your credit score.
Having a good payment history makes it much more likely you’ll repay what you owe again in the future, giving lenders greater confidence in you as a potential customer.
2. A loan can build your credit history
If you have limited experience of managing debt, you may have a thin credit file. This could make it trickier for you to borrow money, as lenders can’t see how you’ve handled money in the past.
Applying for a personal loan could help to build your credit history. Repaying what you owe on time each month will prove you can handle debt responsibly. This could help you to obtain credit again in the future, perhaps at a better rate.
3. Instalment credit can improve your credit mix
You may have a strong track record of managing revolving credit (such as a credit card), but little evidence of handling instalment credit (such as a personal loan). In this instance, a personal loan could help to improve your credit mix, potentially giving your credit score a boost at the same time.
That’s because revolving vs instalment credit requires different types of money management and proving you can handle both can reflect positively on you as a borrower.
Revolving credit allows you to borrow up to a maximum amount, with the option to repay and borrow again repeatedly with no set deadline for clearing your balance. Other than paying the minimum balance off, it’s up to you how much you pay off and when (though you’ll incur interest charges if you don’t clear your balance each month). This type of credit is perhaps most suitable for making several smaller purchases, allowing you to pay back the money you owe more flexibly.
Instalment credit is a more structured way of borrowing. You’ll borrow a set amount of money and agree to repay it within a specific timeframe by making a series of equal monthly payments. You’ll always know how much you need to repay each month and when. While this can help you to manage your outgoings, you won’t have much flexibility if your financial situation changes. This type of credit is best suited for larger, one-off projects or purchases such as buying a car or undertaking home improvements.
The maximum amount you can borrow using revolving credit is likely to be much lower compared to types of instalment credit. In turn, your monthly repayments are likely to be higher when repaying instalment credit.
As you can see, both types of credit are very different. Demonstrating you can confidently manage revolving and instalment credit could have a positive impact on your credit history.
Using a personal loan to lower your credit utilisation could help you to manage existing debt
Taking out a personal loan to consolidate high-interest credit cards could help to lower your credit utilisation. Debt consolidation works like this: you take out a loan and use the money to pay off existing debt. You’ll then have just one monthly repayment to think about.
Your credit utilisation is what percentage of your total available credit you’ve used. It most often refers to credit card usage, giving a lender a glimpse into how you use revolving credit. For example, if you’re maxing out your credit cards and typically only paying off the minimum balance, this could be a red flag compared to someone who uses below 30% of their credit card limit (the desired amount) and pays off the balance in full each month.
You can use a debt consolidation loan to lower your credit utilisation which may have a positive effect on your credit profile. But, perhaps more importantly, it could help you to manage your debt more effectively. Instead of having several monthly repayments to manage, you’ll have just one. And, depending on the level of interest paid on your loan compared to the debts you consolidate, you could even potentially reduce your monthly outgoings.
In general, finding a more manageable way to handle your debt means you’re more likely to keep up with your repayments and pay off what you owe on time which could have a positive impact on your credit history.
For a loan to build credit, you must be accepted first
A personal loan can only positively contribute to your credit report if your loan application is accepted. So it’s important to do your research ahead of applying. Make sure you are eligible to apply with your chosen lender and ask yourself these important questions before hitting that ‘apply now’ button.
Remember, applying for a loan will trigger a hard credit search on your file, which will be visible to other prospective lenders in the future. While the outcome of an application won’t be recorded, too many hard searches over a short timeframe could suggest financial instability, which could put lenders off accepting your application.
It’s therefore important to limit the number of loan applications you make, ensuring you only apply if you feel confident you’re able to afford the loan. Our online loan calculator can help with this by allowing you to work out how much a loan could cost you each month and in total.
Never take out a loan just to build credit
If you have a less-than-perfect credit history, you may think that getting a personal loan could be a good way to fast-track your way to a better credit score.
However, this is an extremely risky strategy and it’s never recommended to get a personal loan (or any form of credit for that matter), unless you really need it.
That’s because any late or missed payments could have a significant negative impact on your credit score. Negative information stays on your credit report for up to six years, too, so you could find that past debt mismanagement could continue to impact your ability to borrow for many years to come. You must be absolutely confident you can afford your monthly repayments before applying for a loan.
Your loan is also likely to be more expensive if you have a negative credit history or thin credit file. Lenders will likely offer you a high interest rate as you represent a greater risk of defaulting on your repayments. This means your monthly payments will be higher, which could potentially put strain on your finances. Again, think very carefully before going ahead and taking out a loan if you think it may become unaffordable later down the line.
A personal loan could also impact your debt-to-income ratio (basically what percentage of your monthly income goes towards repaying debt). While this information isn’t available on your credit report, lenders will take debt-to-income ratio into account during their affordability checks. Where a personal loan increases your debt-to-income ratio, a lender may not wish to lend you any more money until you’ve cleared some of your existing debt.
Our guide on how to build credit history provides further insight on what to do if you have a thin credit file. You could also consider alternative ways to build credit, such as opting for a credit builder card.
Sophie Venner is a Yorkshire-based content writer specialising in crafting content for the financial services industry. She’s written over 300 articles on finance, but she’s covered everything from insurance to digital marketing trends. Her content has been featured in the likes of Semrush, Digital Marketing Magazine and Insurance Business. In her spare time, you won’t find Sophie far from a notepad and pen as she squirrels away trying to write a novel.
Wednesday 23rd August 2023