Building or improving your credit is a critical step toward financial stability, but is taking a loan the best way to do it? The answer depends on your financial situation and how responsibly you manage the loan. Using a loan to establish a payment history and diversify your credit mix can boost your credit score.
When asked, โIs it smart to take a loan to build credit?โ Matt Mayerle, Personal Finance Editor at CreditNinja, says, โTaking a loan to build credit can be a smart move if done responsibly. Loans like credit-builder loans or small personal loans can establish or improve your credit history when payments are made on time. However, itโs essential to borrow only what you can afford to repay and to ensure the loan terms, like interest rates and fees, align with your financial goals.โ
This article explores when itโs wise to take a loan for credit-building, the risks involved, and how to make it work in your favor.
By the end, youโll know exactly how to use this tool to build credit like a pro.
What Are Online Loans and How Do They Work?
Online loans are exactly as they sound; they are loan products you can apply for and manage online. Personal loans, payday loans, and installment loans are all sorts, and they come in different sizes.
Hereโs the basic gist:
You apply for a loan, get approved (hopefully), and then you borrow. The amount you borrow, plus interest, is repaid in agreed-upon installments over the course of the loan.
The big plus: Convenience. Everything is fully online, and some lenders donโt even require traditional credit checks to approve you.
How Online Loans Affect Your Credit
Online loans can impact your credit in both amazing andโฆ less-than-amazing ways. It all comes down to how you manage them.
The Good Stuff
- Build a Credit History
An online loan can light up your credit report if youโre just starting and have no credit history. Lenders report your payments to the major credit bureaus (like Experian, Equifax, and TransUnion), which means youโre developing a record that future lenders can see.
- Boost Your Payment History
Making on-time payments is a massive win for your credit scoreโpayment history accounts for 35% of your FICO score (yes, itโs that important!). A successfully managed loan can give this metric a hearty boost.
- Improve Credit Mix
Your credit profile should have both revolving credit (credit cards) and installment credit (loans) because lenders like to see diversity in your credit profile. An online loan may help you out and add to your credit mix, making you appear like a well-rounded borrower.
The Potential Risks
Of course, itโs not all roses and sunshine. But, like with any other loan, online loans can also be risky to your credit if things donโt go to plan.
Mayerle warns, โTaking out a loan without fully understanding the terms can lead to financial setbacks. High interest rates, hidden fees, or missed payments can negatively impact your credit score and create more debt than you intended to manage. Always read the fine print and plan your repayments carefully.โ Consider these risks when evaluating loan offers:
- Missed Payments
Miss just one payment, and your score could drop significantly. Late or missed payments are red flags to lenders, and theyโll cling to your credit report for years.
- Credit Pulls
Some lenders will run a hard credit inquiry during the application process and can slightly ding your score. This is normal, but applying for several loans in a short period of time can cause your score to drop faster than youโd expect.
- Loan Scams
Yes, they exist. Some online lenders may not be legitimate and are trying to scam borrowers with hidden terms or hidden fees. You could end up in financial ruin based on a bad experience.
How to Use Online Loans to Build Credit the Right Way
Used carefully, online loans can be an excellent credit tool. Hereโs how to make them work for you without falling into financial traps.
1. Do Your Research on Lenders
Not all lenders are created equal, and there are some sketchy ones out there. Stick with reputable companies that clearly outline their terms and are trusted in the industry. Before signing anything, look for reviews, Better Business Bureau ratings, and clear customer testimonials. CreditNinja is just one example of a popular and trustworthy provider of online loans. Doing your research before making any hasty decisions will help you to make the right choice when it comes to choosing a trusted provider.
2. Borrow Only What You Need
It can be tempting to max out your loan approval amount, but over-borrowing is a surefire way to end up in hot water. Remember, youโre responsible for repaying that money. Don’t bite off more than you can chew.
3. Make Payments On Time, Every Time
The only rule you should remember: never, ever miss a payment. Instead, set reminders, use autopay, or pencil it in your planner. Late payments cause a lot of damage, so keep your payments consistent. If youโre losing the race when it comes to payments, contact your lender and find out if they provide any flexible payment options.
4. Have a Repayment Plan
Before borrowing anything, figure out how youโll pay it back within the terms. No guessing. Have a clear plan for covering each payment, even during financially tougher months. When you’re proactive with your repayment plan, you can avoid defaulting on the loan and falling into a financial hole.
5. Avoid Unnecessary Applications
Each credit inquiry dings your score a little, so donโt overdo it. Only apply for a loan after youโve carefully considered your options and determined itโs necessary. To be safe, space out loan applications by at least six months to avoid multiple hard credit pulls in a short time.
6. Leverage Tasting Notes From Each Loan
Compare and contrast the terms versus your personal/budgetary needs over time while using easy, effective repayment tools like apps for reminders and more. Leverage this info as a personal benchmark for future needs.
7. High Loan Costs
Some online loansโlike payday loans or bad credit loansโcan be very expensive due to their fees and repayment terms. However, many other loan options are much more affordable. Missing a payment on these costly loans can quickly lead to escalating balances.
When Should You Consider an Online Loan for Building Credit?
Online loans arenโt always the best or only way to build credit. If your situation is such that alternatives like secured cards, credit builder loans, or becoming an authorized user on someone elseโs account make more sense, though, it might depend on your situation.
You should only consider an online loan if:
- Youโre confident you can make payments on time
- The terms are fair
- You have a specific financial goal fueled by the loan (e.g., consolidating debt or covering emergency costs)
As Mayerle recommends, โAn online loan can be a good option for building credit if youโre confident you can make consistent, on-time payments. Itโs most effective when you have a clear financial goal, such as improving your credit score or consolidating debt, and when the loan terms are fair and manageable.โ
If any of the above doesnโt apply to you or your loan, hit pause and explore other credit-building strategies.
Wrapping It Up
Building credit with online loans doesnโt have to be overwhelmingโyou just need a clear strategy and a pinch of responsibility. By sticking with trusted lenders, borrowing wisely, and staying on top of payments, you can turn an online loan into a powerful step toward a stronger credit profile.
But remember, every financial toolโno matter how shinyโcomes with risks. Proceed with caution, and always know your limits.
If navigating the loan landscape still feels tricky, donโt hesitate to reach out to financial experts or use online learning resources. Your future credit score will thank you.