It may seem ironic that you have to accrue debt before you can achieve great credit, but logic and reason stand behind this seemingly odd approach.
Before lenders sign a check, they want to know they can trust you to pay it back. A credit score helps lenders gauge how well you handle money by analyzing your past experiences.
However, if you've never borrowed money before, there are no past experiences to vouch for you. In order to build a positive credit score, you need to take out a loan of some kind and prove you can pay back your dues on time.
One way to do this is through a small loan. Read on to discover how you can use a personal loan to build credit.
An Introduction to Personal Loans:
A personal loan is a pretty general term. It refers to any kind of unsecured loan that an individual borrows in order to buy something they cannot afford upfront or to cover a debt.
These loans often range between $1,000 and $100,000. However, if you're simply trying to improve your credit score, it's better to start small.
So what sets a personal loan apart from other loans, such as a mortgage? The term "unsecured". Personal loans have no collateral to cover them should the borrower fail to pay it back.
Because of this, personal loans have higher interest rates than secured loans. This rate varies based on your credit score. The better your score, the better your rate.
However, even if your credit is poor, personal loans are often still a better deal than credit cards, whose interest rates are typically 10 to 20 percent, at least.
Personal loans are also unique in that they're money in your pocket. Other loans are specific to certain purchases, such as a car, house, or education. Whatever money you receive from a personal loan is yours to spend as you choose.
How to Use a Personal Loan to Build Credit:
So how do you use a personal loan to improve your credit? It starts by taking out a fair loan, but it ends with responsible management.
There are several things to keep in mind before you sign the dotted line. Here are 4 tips on how to properly use a personal loan to improve your credit.
1. Your Personal Loan Should Be Spent Wisely
Don't just take out a personal loan and go on a shopping spree. Be smart about how you spend the funds. Most people use personal loans to cover or combine a debt into easier payments with lower interest.
For example, you can use a personal loan such as student loan refinancing to pay off your student debts and get a better interest rate. If it's one loan, you're simply transferring your debt from one lender to another.
However, if you cover multiple loans, it's called debt consolidation. Simply put, debt consolidation is coupling multiple loans together into one lump sum under one lender.
This is advantageous when you go through a lender who provides a lower interest rate that saves you money in the long-run.
2. Personal Loans Should Be Paid Back Quickly
Your personal loan shouldn't be like a mortgage, especially if you're just trying to improve your credit. Depending on the amount you take out, you should look to pay it back within less than 5 years.
If you spend too long paying back a personal loan, you end up paying far more out of pocket. Beyond that, having a lingering debt can hurt your credit score. This is especially true if you accrue more debt during that span of time or you fail to make the minimum payments each month.
3. Use a Personal Loan to Get Ahead, Not to Kick the Can
A personal loan should help you, not delay your debt repayment. Remember, this method is designed to improve your credit standing, but it won't work if you dig yourself deeper into debt.
Create an action plan for paying back this debt, and be mindful of the terms you sign. Not all personal loans are the same. You'll want to avoid taking out a loan that penalizes you for paying in full before the term is up.
A fixed-term can help you prevent your loan from exceeding your pay-off timeline. If you can combine that with a fixed interest rate, even better. These two terms can help protect you from getting tangled in a web of penalties and interest debt.
4. Always Weigh Your Options and Have a Plan First
A personal loan can help your credit, but it shouldn't be your go-to solution. Consider all of your options. While credit cards have a high-interest rate, if you can pay them off within a few weeks or months, it may prove to be a better solution.
Secondly, have a plan of action in place before you take out a loan. Credit scores reflect how you handle money. If you take out a loan without budgeting for an efficient repayment, your attempt to improve your credit score can backfire.
If you don't have a monthly budget already, create one. Factor your fixed and variable monthly expenses, then fit your loan payment into that calculation. If you can't afford the loan, but need it, take a step back and identify the challenge.
What can you cut back on? Are you spending too much on unnecessary items and impulse purchases?
Simple lifestyle changes such as cooking from home instead of eating out can help you cut back on your spending significantly.
But what if you've analyzed your budget and found no room for cuts? Sometimes we find ourselves living on a shoestring budget that simply doesn't align with today's cost of living.
If this is you, consider finding a new job or a side gig that can increase your monthly income. Earn enough to make a living while living within your means.
Improve Your Financial Wellbeing:
Taking out a personal loan to build credit is only one of many strategies you can use to improve your financial options. Expand your knowledge with our articles on financial topics.
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