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Can You Repair Your Credit With a Personal Loan?

| Money Rates Columnist.
min read

group-of-young-peopleGot a lower than desirable credit score? You may be able to boost that score and repair your credit by getting a personal loan.

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Is Credit Repair With a Personal Loan Possible?

Got iffy credit? Want to appear more creditworthy to lenders? A personal loan can help. There are several ways that applying for, getting approved, and responsibly paying off a personal loan can repair your credit.

When you apply for an account or loan, the financial institution is going to take a good long look at your credit report. If they see in your history that you've had a personal loan, for which you made prompt payments, you will appear as a more favorable borrower candidate.

Moreover, being a personal loan borrower can raise your credit score. That's an instant form of credit repair right there.

How Can a Personal Loan Raise Your Credit Score?

If you have a FICO score below 640, you've got a problem. That's because scores under this threshold are considered fair or worse and could hurt your ability to get financing or qualify for a lower interest rate.

But if you need extra money, you may be able to boost your credit score with a personal loan.

First, having a personal loan helps you build a payment history - and that's 35% of your credit score. By paying your personal loan payments monthly in full and on time, you can raise your credit score.

Likewise, adding a personal loan to your mix of credit (15% of your score) can help because installment loans are considered a higher grade of credit than revolving accounts like credit cards. Having one or more credit cards, an auto loan, and a personal loan shows that you aren't too reliant on any one type of credit.

What's more, adding a personal loan to your credit mix decreases your credit utilization ratio (which comprises 30% of your FICO score). If your credit cards have a total limit of $5,000 and you're using $4,000, that's an 80% utilization ratio, and that's pretty bad. But pay them off with a $4,000 personal loan and your utilization drops to zero.

How Do Personal Loans Repair Credit?

There are other ways in which using a personal loan can repair your credit.

Say you have a very low credit score or no credit history. In this case, it's going to be hard to get approved for a personal loan. But you can pursue one type - a credit-builder loan. With this loan, you don't get the funds you seek until you pay fixed monthly amounts toward the amount you aim to borrow. After you completely pay off your principal plus interest, then you get your money. If you make your payments on time, your credit score will go up.

Personal loans can repair your credit if you use them to pay a collection accounts. If you have a medical collection, the creditor has to remove the collection from your credit report (and score) once you pay it. For other collections, you may be able to negotiate the removal of the blemish from your credit report as a condition of repayment.

Note that repaying very old collections might not improve your score by much. While getting new ones off your report may help a great deal.

Repair Credit With a Personal Loan the Right Way

Getting approved for and paying down a personal loan on time and in full each month will certainly help your credit. But it's important to follow best practices when using a personal loan to ensure that your credit score continues its upward trend.

First, calculate how much you can afford to borrow and pay back monthly. This involves carefully crafting a budget. It requires forecasting how much you expect to earn and devote to repayments over the loan term. Use a personal loan calculator to help you crunch these important numbers.

Second, borrow only the funds you truly need. It may be easier than you think to get approved for tens of thousands of dollars. But do you really need that much? Consider what you plan to use the money for carefully. Using it to pay off high-interest revolving debt can be wise. However, taking the money to pay for a boat is probably a bad idea. And, for example, needing only $10,000 but taking out the full $20,000 you're approved for can get you in trouble; it can be tempting to spend that extra money on indulgences, and you'll be paying interest on that excess cash, too.

Also, plan on shopping around and comparing interest rates from several different lenders. If you take the first offer you get, you could spend a lot more in interest over the life of your loan than if you'd weighed offers from various lenders.

When Can't You Fix Credit With a Personal Loan?

Personal loans carry risks, too. One of these risks is that carrying a personal loan can damage your credit. There are several reasons why this can happen.

First, consider the obvious: Getting a personal loan means being responsible for more debt. If you don't pay your personal loan off punctually - meaning the full balance due each month before the deadline date - you could hurt your credit. Or say you use personal loan funds to whittle down your high-interest credit card debt, but you keep overcharging on that plastic. In this case, you may dig yourself into a debt hole you can't easily get out of.

Second, some personal loans come with fees. These can include application, origination, administrative, processing, and late fees. You might need to borrow enough funds to pay off these fees, too. That could put you further into debt than you had hoped.

Third, applying for a personal loan triggers a hard check on your credit report by the lender. This hard inquiry can lower your credit score, although only for a few months. But an excessive number of hard credit checks can have a more lasting effect on your score.

Other Options to Build or Repair Credit

Acquiring a personal loan isn't the only way to fix your credit problem. Consider these other strategies, too:

  • Apply for a secured credit card. You need a cash collateral deposit, which functions as a credit line for the account, to get one of these cards.
  • Apply for a credit card from a retail store. A retailer may be more inclined to approve someone with poor credit. Just be sure only to charge what you can afford to pay off in full each month.
  • Don't apply for two or more credit accounts too close together. Spread out your applications by several months to avoid dinging your credit.
  • Check your three credit reports for free once a year. Review all information carefully, and dispute any errors you notice by contacting Experian, Equifax, and/or TransUnion.
  • Pay off your other debts punctually. That means making credit card payments, auto loan payments, mortgage payments, and student loan payments on time for the full amount due each month.

Personal loans can be part of a sound credit repair strategy. Just make sure that you understand how you got into trouble in the first place and create a solid plan to avoid repeating the mistakes of the past.

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