Millennials face unique financial challenges with student loan debt, housing costs and economic uncertainty affecting this generation disproportionately, many are looking for strategic ways to improve their credit profiles.
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The generation, aged 27 through 42, is not scoring far above Gen Z, with a 690 average, suggesting significant room for improvement compared to older generations who typically have higher scores.
Personal loans can be a powerful tool for millennials to boost their credit scores when used strategically.
Here are six specific ways a personal loan can help improve your credit standing and set you up for better financial opportunities.
Debt Consolidation Reduces Credit Utilization
One of the most effective ways a personal loan can boost your credit score is through debt consolidation. Debt consolidation works by paying off existing debts with a new loan or balance transfer credit card, according to Experian. This can be a good strategy when you have multiple balances because it allows you to streamline your monthly payments, which can make getting out of debt more manageable.
When you use a personal loan to pay off high-balance credit cards, you’re essentially moving revolving debt to installment debt. This shift can dramatically improve your credit utilization ratio, which accounts for 30% of your credit score. Combining multiple credit cards with a debt consolidation loan could provide a large boost to your scores since it reduces your credit utilization ratio.
For example, if you have $8,000 in credit card debt across multiple cards with a total credit limit of $10,000, your utilization ratio is 80%. By consolidating this debt with a personal loan and paying off the cards, your utilization drops to 0%, which can result in a significant credit score increase.
Establishes Consistent Payment History
Payment history plays the biggest role in your credit score, making up 35% of it, according to Faster Capital. Personal loans provide an excellent opportunity to establish a consistent track record of on-time payments, and debt consolidation loans could even benefit your credit score if you keep payments consistent, according to Lending Tree. As you pay off your debt, you’ll reduce your debt-to-income ratio and demonstrate to creditors that you can make timely payments. Over time, this can boost your credit score.
Unlike credit cards where payment amounts can vary, personal loans have fixed monthly payments that make budgeting easier. This predictability helps millennials build a strong payment history, especially those who struggle with variable income or budgeting challenges. Setting up automatic payments for your personal loan ensures you never miss a due date, protecting and improving your credit score over time.
Diversifies Your Credit Mix
Credit scoring models favor borrowers who can successfully manage different types of credit accounts. Another factor of credit scores is the type of credit one has. Creditors like to see a diverse mix of both revolving and installment credit. Many millennials primarily have revolving credit (credit cards) and possibly student loans, but lack other forms of installment credit.
Adding a personal loan to your credit profile creates a more diverse credit mix, which accounts for 10% of your credit score. This demonstrates to lenders that you can handle various types of credit responsibly, potentially boosting your score and making you more attractive to future lenders.
Provides Lower Interest Rates Than Credit Cards
Personal loans typically offer lower interest rates than credit cards, especially for borrowers with decent credit. Personal loan rates start as low as 7% for qualified borrowers, compared to credit card rates that often exceed 20%. This interest rate advantage serves two credit-building purposes.
First, lower interest rates make it easier to pay down debt faster, reducing your overall debt burden and improving your debt-to-income ratio. Second, the money you save on interest can be redirected toward other financial goals or building an emergency fund, creating a more stable financial foundation that supports long-term credit health.
Helps Build Credit History Length
For younger millennials or those with limited credit history, a personal loan can help establish a longer credit history timeline. The length of your credit history accounts for 15% of your credit score, and having accounts that remain open and in good standing for extended periods benefits your score.
Personal loans typically have terms of two to seven years, providing a multi-year opportunity to demonstrate responsible credit management. As the loan ages and you maintain good payment history, it becomes increasingly valuable to your credit profile, especially if you have limited credit history from other sources.
Offers a Fresh Start for Credit Repair
For millennials dealing with past credit mistakes, a personal loan can aid with repair. If you can lower interest rates and payments through debt consolidation, your credit score will be less likely to be damaged due to a better shot of meeting your monthly payment, per Equifax.
By consolidating multiple debts into a single personal loan with a clear payoff timeline, millennials can regain control of their finances and establish new positive payment patterns. This approach is particularly effective for those who have struggled with credit card debt or multiple payment obligations that have become unmanageable.
Important Considerations Before Applying
While personal loans can be powerful credit-building tools, millennials should be aware of potential drawbacks. Simply applying for a personal loan or balance transfer credit card will result in a hard credit inquiry from the lender, docking your credit score a few points, according to CreditKarma. However, this temporary dip is usually offset by the long-term benefits of improved credit utilization and payment history.
Additionally, if you want to qualify for one of the best personal loans, you typically need good or excellent credit (600 and higher), though some lenders work with borrowers who have fair credit. Millennials should shop around and compare offers from multiple lenders to find the best terms available for their credit situation.
Personal loans can be an effective credit-building strategy for millennials when used responsibly. The key is to view the loan as a tool for financial improvement rather than additional spending power. By consolidating high-interest debt, establishing consistent payment history, and diversifying your credit mix, a personal loan can help bridge the gap between where your credit stands today and where you want it to be.
With millennials (many of whom are now entering their 40s) saw a 10.4% increase in personal loan balances, it’s clear that this generation is already utilizing personal loans as part of their financial strategy. When approached strategically, these loans can be a steppingstone to better credit scores and improved financial opportunities.
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This article originally appeared on GOBankingRates.com: 6 Ways a Personal Loan Can Help Millennials Boost Credit Scores
