Can you actually repair your credit by borrowing more? In some cases, you can. The personal loan for credit repair is a tool that, used by the right people and for the right reason, can improve a credit score.
Who should consider a personal loan for credit repair?
If your credit score is low because you have a short history, or because your credit cards are over-utilized (you are carrying balances and using most of your available credit), a personal loan can improve your score — in many cases, quite quickly.
Should you use a personal loan to pay off collection accounts? In some cases, yes. Paying off a collection account with a personal loan may only be improve your score if the collection isn’t more than a couple of years old. Don’t “restart” the timing of a collection account with new activity if it’s really old. Normally, collections drop off your credit history after seven years.
You may be able to get collection agencies or other creditors to remove bad history from your account by using a personal loan to pay off a collection. You have to negotiate this concession before repaying.
Who shouldn’t repair credit with a personal loan?
But if you’ve lost your source of income, you need more help than a personal loan can offer. If your debt is uncontrolled, a personal loan won’t likely help. Consider non-profit credit counseling or even drastic solutions like bankruptcy if you can’t afford the payments needed to clear your unsecured debt (not your home or car) in five years or fewer.
You may in that case be able to use a personal loan to settle debt you can’t afford. But debt settlement doesn’t typically improve your credit score, at least not in the short run.
How can a personal loan improve your credit?
If you’re a good candidate for personal loan credit repair, it usually works on three fronts. They include payment history (35%), credit utilization (30%), and credit mix (10%). These three elements comprise a FICO score, the most commonly-used scoring model in the US.
Here’s how a personal loan can raise your credit score:
Establish (or reestablish) a positive repayment history. Make your personal loan payment on time each month, and the big three credit bureaus will probably collect that data and incorporate it into your score. Positive repayment equals improved FICO scores. Make sure your lender reports to credit bureaus before borrowing.
Lower your credit utilization ratio. Credit experts recommend using no more than 30% of your credit limits. By consolidating credit card balances and zeroing them out with a personal loan, you reduce this ratio to zero. Personal loans don’t count in credit utilization calculations because they are installment loans with a fixed repayment plans.
Improve your credit mix. Adding installment loans to your mix of credit can improve it if the debts you have now are mainly credit cards. The FICO scoring model rewards consumers for having installment loans like auto financing and mortgages as well.
Understand that applying for a personal loan triggers an inquiry on your credit report. This can temporarily drop your FICO by about five points.
How to successfully build or repair credit with a personal loan
Don’t worsen your credit problems by making these common mistakes:
- Using the loan proceeds for the wrong reasons. You want to reduce your debt loan and improve your credit, not take a vacation to Las Vegas.
- Borrowing too much. Borrowing costs money, so the more you borrow, the more it costs. And borrowing to the extent that you can’t repay your loan on time every single month will likely backfire.
- Running your credit card balances up after paying them off. That’s probably the most damaging and the most common mistake consumers make when they consolidate debt with a personal loan. If you have any doubt at all about your fiscal discipline, see a credit counselor, not a lender.
- Taking out a personal loan without shopping rates and terms. Interest rates for personal loans vary widely among providers, and the money you save on interest could go towards repaying your debt sooner. You can shop for the best personal loan rates right here.
- Taking on an unaffordable payment. Before borrowing, know your total monthly debt payments. Most personal finance experts recommend that you don’t spend more than 36% of your gross monthly income on your debt payments, including housing, student loans, car payments and credit cards (but not living expenses like food and utilities).
Alternative ways to build or repair credit
While a personal loan can be a great tool for building or repairing credit, there are other options.
- Secured credit card. Secured credit card issuers require you to deposit a sum with them to cover some or even all of your desired credit limit. Make sure that you choose one with reasonable fees and that the company reports your history to all three bureaus (Equifax, Experian and TransUnion).
- Peer-to-peer (P2P) loan. Some P2P lenders specialize in making loans to borrowers with limited credit history and even borrowers with poor credit. Pay on time and make sure that your lender reports to all three bureaus.
- Secured installment loans. Auto lenders, for instance can be more forgiving than personal loan providers because they are often affiliated with the auto sellers, and because auto loans are secured by the vehicles they finance, making them less risky.
How personal loans repair credit
To recap, personal loans can repair credit if your main problem is a “thin file,” a short or limited credit history. They can help you improve your score by adding good repayment history, by allowing you to negotiate collections and other derogatory items off of your report, by improving your mix of credit and lowering your credit utilization.
If your credit problems are too big for a personal loan to handle, or if you lack the discipline needed to repay your debt and not run it back up, you need more serious financial help than a personal loan can offer.