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Dos and Don'ts of Using a Personal Loan to Build Credit

Building credit involves taking on some form of debt so you can pay it off and there’s more than one way to do it. Credit cards, for example, offer flexibility and convenience but they tend to come with high interest rates. Taking out a small personal loan, on the other hand, could be better. Following some simple rules can ensure that you help rather than hurt your credit score.

Check out our personal loan calculator.

Do Shop Around for the Best Rate

When you’re in the market for a personal loan, you don’t want to jump on the first offer that comes along. Even if the loan terms look appealing, you owe it to yourself (and your wallet) to see what different lenders are offering in terms of interest rates and fees. The lower these costs are, the more money you’re going to save in the long run.

Don’t Go Overboard Applying for Loans

Thinking that you can up the odds of getting approved by applying with multiple lenders at the same time could be a serious mistake. Any time you apply for a loan, it shows up on your credit report as a hard inquiry and can cause your credit score to dip. Sticking with just one lender that you’re confident will approve your application can minimize the impact on your score.

Do Review the Terms of the Loan Agreement

Dos and Don'ts of Using a Personal Loan to Build Credit

Once your personal loan gets the green light, you’ll need to finalize the deal by signing off on the paperwork. This is not a step you want to rush through.

It’s a good idea to carefully read over your loan agreement before signing on the dotted line. One thing to pay attention to is whether there are any penalty clauses, which could cause your interest rate to increase or alter another loan term.

Don’t Borrow More Money Than You Need

Just because you’re approved for a $5,000 personal loan doesn’t mean you need to accept that much money. If you don’t need the loan for any other purpose than building your credit, you could be better off borrowing a smaller amount instead. That way, you still get the benefit of establishing a payment history without having a huge debt burden hanging over your head.

Do Make Your Payments on Time

The factor that has the biggest effect on your credit score is your payment history. Even one late payment can be devastating.

When you take out a personal loan, your lender will provide you with a detailed payment schedule and it’s critical that you stick to it. If you think you’re going to be late at any time, it’s best to let your lender know immediately to minimize any potential damage to your score.

Don’t Run up Other Kinds of Debt

Dos and Don'ts of Using a Personal Loan to Build Credit

As you make payments on a personal loan you may see your credit score begin to improve. A better score can make you eligible for other types of credit. While it may be tempting to borrow even more, you could be putting your score in danger.

Having multiple lines of credit that are close to their limits increases your credit utilization ratio. A higher debt-to-credit ratio can knock points off your score.

The Bottom Line

Getting a personal loan can be an effective way to improve your credit if you’re using it wisely. Making payments on time and holding off on multiple applications for credit can help boost your score.

Photo credit: ©iStock.com/Yuri_Arcurs, ©iStock.com/PeopleImages, ©iStock.com/Matt_Brown

Rebecca Lake Rebecca Lake has been writing about the nuts and bolts of personal finance for nearly a decade. She is an expert in investing, retirement and home buying topics. Her work has been featured on The Huffington Post, Business Insider, CBS News, U.S. News & World Report and Investopedia. As a homeschooling mom of two, she's always looking for ways to make the most of every dollar.
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