Does a Personal Loan Help Your Credit?

If you want to improve your credit score, you may be wondering: Does a personal loan build credit? It absolutely can -- or it can do the opposite. Depending on your loan's terms, it can also be expensive. Here's what you need to know about getting a personal loan to help your credit score.

Does a personal loan build credit?

A personal loan can build credit if you make the payments on time. There are multiple ways that a personal loan can help your credit:

• The lender reports your on-time payments to the credit bureaus. Each on-time payment builds your payment history, the most important factor in your credit score.
• If you have credit card debt, you can use a personal loan to pay it off. This reduces your credit utilization ratio, which is the ratio of your card balances to their credit limits. Low credit utilization is good for your credit score.
• A personal loan improves your credit mix. It's better for your credit score if you have multiple forms of credit, such as credit cards and a loan, instead of just one.

There are several factors that are used to calculate your credit score. To better understand how a personal loan can raise your credit score, we'll go over each of the factors it can impact. If you know you need a personal loan, check out our list of the best personal loan options to find one.

Payment history

Most personal loan companies report your balance and payment activity to all three credit bureaus every month. Negative reports to the bureaus (like when you miss a payment) drag your score down. Positive reports, like on-time payments, improve your credit score.

If building your credit history is important to you, ask lenders whether they make monthly credit bureau reports before you sign on for a personal loan. A traditional financial institution like a bank or credit union will make monthly credit bureau reports. It's rare to run across a legitimate personal loan lender that does not report your payment activity to the bureaus, but it's always good to double-check.

RELATED: How to Build Credit Fast

Credit utilization ratio

When you use a large portion of your credit, it can cause your credit score to plummet. A common recommendation to avoid this is to keep your credit utilization below 30%. For example, if your credit card has a $10,000 limit, keep the balance below $3,000.

Here's the good news -- if you currently have high credit card balances, a personal loan could help your credit score. You could get a personal loan, and then consolidate your debt by paying off all your credit cards with that loan. This brings your credit card balances and your credit utilization down to zero, which could lead to a big increase in your credit score.

Debt consolidation also saves money

Best of all, getting a personal loan to pay off credit cards can save money. Personal loans tend to have much lower interest rates than credit cards, especially if you qualify for the best low-interest personal loans. You could save hundreds or even thousands of dollars in interest by refinancing your credit card debt with a personal loan.

Credit mix

Your credit mix refers to the types of credit you have. From a lender's perspective, consumers who have demonstrated the ability to successfully manage multiple types of credit present a lower risk.

This doesn't mean you should get a loan and pay interest just to raise your credit score. Credit mix is a small part of your credit profile, and it only makes up 10% of your FICO® Score (the most widely used type of credit score by lenders). But if you want to get a loan for another reason, one benefit is that it can help your credit.

Repairing bad credit with a personal loan

Because of how it impacts your credit, a personal loan can be an effective way to repair a bad credit score. The situation where it's most helpful is when you have a low credit score because of debt. In that case, debt consolidation with a personal loan could help you get your credit utilization down and pay off your debt more quickly. Your personal loan payments will also help your payment history, assuming you make them on time.

However, a personal loan won't be right for every type of credit repair. If you aren't dealing with debt, then you may be better off simply using a credit card regularly and paying it off in full. You can rebuild your credit and payment history this way, without needing to pay interest on a loan.

LEARN MORE: How to Rebuild Credit

Establishing credit with a personal loan

Another reason some people turn to personal loans is to build credit for the first time. This is different from having poor credit because of previous issues. If there isn't sufficient activity on your credit file, then you may not have a credit score yet. Young adults and recent immigrants to the United States often face this challenge.

If you're just starting out with credit, a traditional personal loan may be hard to get. But there are still some effective ways to begin building credit:

• Take out a credit-builder loan. This type of loan is designed for people who are new to credit, and you don't get the money until after you've paid off the loan.
• Take out a secured credit card. This type of credit card requires a security deposit, which is often equal to your starting credit limit.
• Take out a personal loan with a cosigner. The lender will run a credit check on your cosigner, so this is a way to get approved for a loan even if you haven't established credit yet.

A personal loan isn't always the right way to build credit. In many cases, you're better off getting a credit card, since you can avoid interest charges if you always pay your credit card bill in full. But there are times when a personal loan is the right choice, including when you want to consolidate debt or get started with credit using a credit-builder loan.

Still have questions?

Here are some other questions we've answered:

• How do personal loans work?
• How do I apply for a personal loan?
• What is a good interest rate for a personal loan?