If you’re looking to build your credit score with the help of a personal loan, before you do anything, make sure you’re clued up first.
If used responsibly, a personal loan can indeed help to build your credit score. However, it’s not a financial commitment to be taken lightly, and you probably wouldn’t normally just take out a personal loan for the sole purpose of improving your credit score.
In this blog, we’ll be taking a look at what exactly a personal loan is, how it can build your credit score, important things to consider, and alternative credit-building options. So, let’s get stuck in...
What is a personal loan?
A personal loan is an unsecured form of borrowing, and you can typically borrow anywhere between £100 and £15,000. Because it’s unsecured, as the name suggests, you aren’t required to put up any collateral – like your home – to secure the loan.
The interest rate you’re given and how much you can borrow with a personal loan both depend on your credit history. Typically, the best interest rates are saved for those with the best credit history, because they’ve got a track record of being a responsible and reliable borrower.
How can a personal loan build my credit score?
Your credit score is made up of a number of criteria, like:
- Your past payment history
- How much credit you have available to you
- How long you’ve had lines of credit open for
- The types of credit you’re using - i.e. credit cards, store cards, and loans
- How frequently you apply for credit
- Negative information, like bankruptcies and County Court Judgements (CCJs)
So, how does a personal loan help you with any of these?
If you meet all of your monthly repayments in full and on time, this will act like a series of green ticks on your credit history. It’ll show current and future lenders that you’re a responsible borrower, and that you can be trusted to stick to the instalments set out in your agreement.
For lenders, this is a big fat ‘yes!’ It means they don’t have to use up time and money chasing you for what you owe, they can simply sit back and relax knowing you’ll make your payments as required.
Types of credit
They say variety is the spice of life, and that’s no different for your credit score. Lenders like to see that borrowers have handled a mix of credit types, because, in their eyes, it demonstrates responsible credit management.
So, if prior to taking out a personal loan all your lines of credit were the same type – for example all store cards – your personal loan will inject a bit of variety, which will be another tick against your credit report.
Things to consider
Although taking out a personal loan is a perfectly viable option to build your credit score, there are cheaper ways to achieve the same end result.
Personal loans come with an interest rate attached to it, and this additional fee can make them a more costly option. You’ll be charged interest on each of your monthly instalments, and so it’s important that you factor this fee into the overall cost of your loan.
For example, if you take out a £2,000 personal loan that comes with a 20% interest rate and agree to repay it over a two-year term, you’ll end up repaying around £2,450 in total. We’ll delve into it in more detail in the next section, but there could be more cost-effective alternatives to building your credit score.
And remember, the best interest rates are usually saved for people with the best credit histories. While taking out a personal loan might build your credit score and earn you better interest rate offers in the long run, you might have to bite the bullet with a less competitive interest rate deal to get there.
Lines of credit
Another thing to consider is the number of lines of credit you’ll have open once you’ve taken out your personal loan. If, for example, you already have one credit card and two store cards and then take out a personal loan, you’ll have four lines of credit open to you at the same time.
If you have no intention of applying for further credit throughout the duration of your personal loan this might not be an issue. However, if there’s a chance you might want to apply for a different type of credit, your personal loan (along with your credit and store cards) could act against you because you’ve got already access to several sources of credit.
We briefly mentioned earlier that there could be more cost-effective options to build your credit score, and there is: a credit card.
Similar to a personal loan, paying your credit card balance off on time and in full every month will help to build your credit score. However, unlike with a personal loan, you won’t be faced with an interest rate fee – providing you pay off your balance in full and on time every single month, we cannot stress that bit enough! If you don’t pay back the entire balance every month, you will be charged interest.
So hopefully, you’re now feeling more informed around your options. Whatever route you decide to take to start building your credit score, always remember to only borrow what you know you can afford otherwise you could find yourself in a financial hard spot in the future.
Disclaimer: All information and links are correct at the time of publishing.