3 Ways a Personal Loan Can Help You Build Credit

There are many reasons to take out a personal loan. You may have an unexpected emergency, home renovations or a major event coming up. Whatever the reason, taking out a personal loan and paying it back on time can do wonders for your credit, and for some, that’s reason enough to get a personal loan.

Consider This: Key Signs Your Credit Card Is Quietly Wrecking Your Finances

Having a good credit score can lower interest rates on future loans, such as auto loans and mortgages. Lenders will be more likely to approve applications, which can result in better terms for insurance rates, telecommunications and utilities. However, while taking out and paying back a personal loan can boost your credit score, keep in mind that if you can’t pay back your debts on time, it will hurt your score significantly.

Here are three ways that a personal loan can be beneficial for your credit.

Positive Payment History

Taking out a personal loan is an opportunity to show future lenders that you’re responsible and reliable. Your payment history alone accounts for 35% of your total credit score. This shouldn’t be surprising, as the number one goal of a lender is to get their investment back with interest.

Your credit score will reflect the payment history of all types of debts, including credit cards, student loans, mortgages, retail accounts, and personal loans. If you’ve missed payments in the past, taking out a personal loan and paying it back in agreement with the terms can help repair some of the damage done. If your credit is already good, this method can boost your score to the next level.

Check Out: Here’s Why You Need To Monitor Both Your Credit Score and Your Credit Report, According to an Expert

Gives You a Good Credit Mix

Another factor that makes up 10% of your credit score is your credit mix. Your credit mix refers to the types of debts you have. If you’ve only got one form of credit, such as a credit card, this can limit your score. Adding an installment loan, along with other types such as a line of credit or mortgage, demonstrates that you’re able to juggle different types of debt. Because of this, taking out a personal loan will reflect positively on your credit score, according to myFICO.

How to Pay Off Debt with Dave Ramsey’s 3 Steps

Improve Credit Utilization Ratio

Your credit utilization ratio tells lenders how much available credit you have with all of your accounts combined, per Capital One. You can determine your credit utilization score by dividing the combined balances of all your credit accounts by the total credit available to you, according to Transunion.

For example, pretend you have a credit card with $3,000 available and $1,200 owed, a second credit card with $2,000 available and $800 owed, and a line of credit with $5,000 available and $2,000 owed. Added up, you have a credit limit of $10,000 and $4,000 owed. By dividing 4,000 by 10,000, you’ll end up with a credit utilization ratio of 40%.

A high credit utilization rate tells lenders that you’ve already taken on a lot of debt and may have trouble paying back theirs. Because of this, most experts advise keeping your credit utilization below 30% so you don’t scare off lenders.

Credit utilization ratios are a significant factor in the amounts owed portion of your credit score, which makes up 30% of it. The good news is that credit utilization just takes revolving debt, such as credit cards and lines of credit, into account. You can take out a personal loan to consolidate your revolving debt by paying off your balances with the loan and then paying back the loan over time. This will significantly lower your credit utilization score and boost your credit score, per Standard Chartered.

More From GOBankingRates

This article originally appeared on GOBankingRates.com: 3 Ways a Personal Loan Can Help You Build Credit

Read news from 100’s of titles, curated specifically for you.

Already a member? Sign in here