How To Use Personal Loans To Decrease Debt And Build Credit

When used responsibly, a personal loan is a useful way to help you pay off old debt and help you build your credit. While it may be debt, it doesn't have to be scary -- in fact, it can end up being much less scary than other types of debt. Here are three ways to use personal loans to help your finances.

Consolidate Your Debt

There are a few reasons you might want to use a personal loan to consolidate old debt.

  • It wraps everything up into one payment, which is easier to prepare for and which can be set during a time of the month that's more convenient for you.
  • It may be a lower interest rate than your other sources of debt, which saves you money.
  • Payments are set and stable, and additional debt can't be added to it.

There are a few caveats to this. Depending on your credit score, you may not be able to get a loan sufficient enough to cover all your pre-existing debt, or the interest rates may still be high. Its effectiveness is also dependent on your willingness to either close your previous accounts or simply not use them; otherwise, you'll simply tack on more debt. However, you can always shop around at multiple banks and credit unions to find the best interest rate and payments, and consult a financial planner if you think you need help.

Use A New Type of Debt

Your credit score is calculated using multiple types of debt. One debt you may be familiar with if you use credit cards is revolving debt. This type of debt has no set amount, meaning that you can spend as much or as little as you want so long as it's within your limit and that how much you owe at any given time depends on how much you have paid off.

A personal loan is considered installment debt; you start with a set amount, then pay that off in predetermined installments until the total amount is paid off. A personal loan is a good way to add a new kind of debt to your credit score because it represents a different way you're capable of being responsible with debt. For this reason, when you have a personal loan, it's a good idea to pay it out over the duration of the term rather than paying it off early. This shows your ability to pay off debt over a long period of time rather than paying off varying amounts of debt with no set limit. By paying off installment debt to term and without missing payments, you can noticeably improve your credit score.

Use Loans Only When Necessary

There are many ways you can use personal loans, but exercise caution when thinking about taking one out. While loans can help you with past debt and building your credit, there are some things you should resist taking out loans for:

  • The explicit purpose of building credit. You'll still pay interest, so it's better to wait until you actually need it.
  • Vacations or celebrations. These are often short but will leave you with potentially years of debt.
  • Home improvements. They may still be viable options, but home equity loans may offer better interest rates since they're using your house as collateral, so start there.

Personal loans are still forms of debt and require some planning and care, so make sure you can afford to repay the loan if you decide to take it out. If you can, however, the benefits are worth it.