Unsecured loans can or cannot be a good way to build your credit score

Ailsa Adam April 5, 2024

Unsecured loans, known as personal loans, can have short and long repayment lengths. Many people address these loans as instalment loans, assuming that they are always paid off over a period of time, at least three months, but not all personal loans are subject to instalment payments.

An unsecured loan is a sum of money you borrow from a direct lender or a bank without securing against collateral. It means you are not at risk of losing your valuable assets if you make a default. These loans can be small or big in size, varying repayment lengths.

When the loan is too small, usually in case of emergencies, the whole sum will be paid back in full on the due date, with a repayment length of not more than a month. Instalment payments are set for larger personal loans.

Unsecured loans are advertised as a panacea to do up your credit score. You will make payments over time, and you will see a significant improvement in your credit rating. There are several things you should know before using these loans to improve your credit report.

Small, unsecured loans cannot do up your credit file

Small emergency loans such as payday loans are also a type of unsecured loans. These loans do not require collateral even if your credit rating is bad. In fact, they are aimed at subprime borrowers. The amount of these loans is usually not more than £1,000. They are obtained to fund emergency expenses.

This is why most of the lenders do not hesitate to lend you money despite your bad credit rating. These unsecured loans for bad credit do not involve a hard credit check, which means no information is recorded about these loans on your credit file. As a result, no information about your payments will be made to your credit file.

Lenders often want to see whether you manage to pay off your credits despite financial troubles, and this idea can be perceived when you are to pay down the debt over time. Since small emergency loans are settled once and for all, it is unlikely that they will help you improve your credit score.

As no hard inquiries are made on your credit file, you can assume that no defaults will be recorded on your credit report. You are all wet if you think so. A lender will immediately report your default to credit reference agencies, which will take a toll on your credit points and ruin your chances to qualify for lower interest rates.

Large unsecured loans can help improve your credit score

Larger personal loans are paid off over the course of time. Since you will be paying back the debt in fixed instalments, you will see your credit score improve. A £4,000 money loan, for instance, can improve your credit score because it will be paid down in fixed instalments over a few months. In order to see your credit score getting better, you must abide by payment terms and conditions.

However, things are not as simple as they seem. Not all lenders are bound to report your on-time payments to credit reference agencies, so you should confirm it before taking out a loan. Do not be under the impression that your credit score will jump from the bad range to the good range even if you repay the debt on time.

Previous defaults and missed queries will not disappear. Despite your timely payments, you will face difficulty qualifying for better interest rates. When these inquiries become old, lenders will not bother about them and might be willing to offer you affordable interest rates. You cannot improve your credit score overnight. It can take months or years.

Other factors also come into play to maintain a healthy credit report. For instance, your credit mix, credit card balance, and debt-to-income utilisation are some factors that can affect your credit rating despite making payments on time.

How should you improve your credit score?

Credit score health should be maintained to avail yourself of loans at affordable interest rates. You simply do not need to rely on unsecured loans to do up your credit rating. These loans can be expensive and you can fall into debt. The following tips will rather help you improve your credit file.

Take out a credit builder loan

Credit builder loans are exclusively aimed at improving your credit score. These loans last for up to between six and 24 months depending on the sum you borrow. These loans can be expensive, but they are manageable to pay off.

Reduce your credit utilisation ratio

A high credit utilisation ratio can call your creditworthiness into question. It indicates that you, most of the time, rely on credit. Maintain this ratio up to 30%. You should pay off the balance before your credit card issuing company reports your balance to credit reference agencies.

Credit mix

You should be able to show that you can responsibly manage your debts, and therefore, it is vital to have different types of credit. If you use only credit cards, you will not be able to avail yourself of lower interest rates despite paying off the whole balance.

Pay off debts on time

No strategy can work better than paying off your debts when it comes to improving your credit score. Make sure you stick to your payment plan.

To wrap up

Small unsecured loans paid off in a lump sum cannot help improve your credit score, but the reverse is the scenario when you borrow a larger sum paid off over a period of time. Unsecured loans should be used to fund your personal expenses, not to improve your credit score. Instead, you should take out a credit builder loan. Pay off your debts on time and reduce your credit utilization ratio.

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