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Building Credit with a Loan: Is It a Smart Move?

By Caesar

Did you know that around 35% of people use loans to improve their credit scores? Building credit is important for better loan terms, lower interest rates, and more financial stability. For instance, if you are searching for a personal loan in Bangalore, you should understand how loans can affect your credit score. But can taking out a loan help your credit? Let’s explore how loans can impact your credit and whether it’s a smart choice.

How do Loans Help Build Credit?

The most direct impact of taking out a loan and making on-time payments is on your credit score. About 35% of your score comes from payment history. You’re showing lenders that you’re reliable by paying your loan consistently, and this will improve your score. 

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You also have a mix of credit types, such as loans and credit cards, which account for 10% of your score. So, a loan can strengthen your credit profile. Moreover, keeping a low balance on loans increases your credit utilisation rate, contributing 30% to your score. Lower utilisation can increase your credit score by 30 to 50 points.

Benefits of Using a Loan to Build Credit

Using a loan to build credit offers several key benefits. For instance, on-time loan payments can increase your credit score by 50-100 points, depending on your starting score. A higher credit score can result in lower interest rates, saving you thousands of rupees on future loans. For example, in a scenario where you will get a loan at 12% interest instead of 16%, on a ₹5,00,000 loan over five years, you can save more than ₹50,000. Plus, a better score implies a greater number of financial possibilities, such as higher credit limits or approval for larger loans.

Types of Loans to Build Credit

Some loans are better than others to build credit. Personal loans are very popular because they have fixed repayment terms and can help improve your credit mix. You can see an increase in your credit score of 30-50 points within a few months of making on-time payments. Another option is credit builder loans. These small loans hold your funds in a bank account until you repay the loan. Every time you pay, the lender sends the credit information to credit bureaus. Secured loans like auto loans have lower interest rates as they are secured but carry the risk of losing your assets if the payments are not made.

Potential Risks of Building Credit with a Loan

Loans can build credit, but they do come with risks. A missed payment can reduce your credit score by up to 100 points. High-interest loans can quickly become costly and hard to pay back. For instance, if you take a personal loan at 20% interest on a ₹5,00,000 loan, you will have to pay an extra ₹1,00,000 in interest over the year. Over-borrowing also leads to debt piling, which damages your credit score.

Tips for Using Loans Wisely to Build Credit

You can only take out loans that you can afford to repay. Over-borrowing is a high-risk activity that may lead to missed payments and debt. A third of your credit score is based on your payment history. Keep your debt-to-income ratio below 36%, which is considered ideal for credit health. By following these guidelines, you can improve your score by 50-100 points over time.

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Comparison of Loan Types for Credit Building

Here’s a comparison of different loan types for building credit:

Loan TypeAdvantagesDisadvantagesBest For
Personal LoansFlexible, improves credit mixHigher interest rates for poor creditBorrowers looking to improve credit
Credit Builder LoansDesigned for credit buildingSmall loan amounts, funds held until paid offFirst-time borrowers or no credit
Secured LoansLower interest rates, collateral-basedRequires collateral, risk of losing the assetBorrowers with assets to pledge

Key Features Comparison Table

FeaturePersonal LoansCredit Builder LoansSecured Loans
Loan AmountVaries (typically larger)Small loan amounts (under ₹1,00,000)Varies (based on collateral)
Interest RatesModerate to High (10-25%)Low to ModerateLow (due to collateral)
Collateral RequiredNoNoYes (e.g., car, home)
Impact on CreditBuilds credit when repaid on timeBuilds credit with on-time paymentsBuilds credit and offers lower rates

Conclusion

Taking out a loan to build credit can be a smart move, but only if it is done responsibly. Borrowing within your means and making on-time payments can boost your score by 50-100 points over several months. However, be cautious of high-interest loans and the risk of accumulating debt. Understanding how loans work for credit building will help you make informed decisions and improve your financial future.

Frequently Asked Questions

Q. Can a loan really improve my credit score?

Yes, on-time payments can increase your credit score by 50-100 points.

Q. What is a credit builder loan?

A small loan designed to help build credit by reporting timely payments.

Q. What occurs if I fail to make a loan payment?

Your credit score may drop by up to 100 points, and you may face fees.

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