Can I Use a Personal Loan to Improve My Credit Score?
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Personal loans provide a lump sum of money that can be used for a variety of purposes — from weathering a financial emergency to consolidating credit card debt. The application process is generally pretty straightforward, and borrowers tend to get their money in a relatively short time frame.
A personal loan could potentially give your credit score a nice boost, but it depends on how you handle the loan. Borrowers who miss payments or don’t do their homework could wind up hurting their score. This is precisely why it’s so important to understand how to make a personal loan work for you.
- How can a personal loan improve your credit score?
- How to get a personal loan
- Other ways to improve a poor credit score
- Should you take out a personal loan?
How can a personal loan improve your credit score?
Here are some ways that a personal loan, coupled with good financial habits, could help boost your credit score.
By lowering your credit utilization ratio
Your credit utilization ratio, an important factor in your credit score, is based solely on your revolving accounts (i.e., open credit lines). Personal loans, on the other hand, are installment loans that cannot be charged up and paid off along the way.
So when you take out a personal loan to pay off credit card balances, doing so effectively lowers your credit utilization ratio and could, in turn, boost your score.
“It could be enough, by paying off those balances, to push your credit score from a B to an A,” said Melinda Opperman, executive vice president with Credit.org.
A few quick things about keeping a healthy credit utilization rate: Experts generally recommend keeping your credit utilization ratio below 30% because a high utilization ratio could negatively affect your credit score. Let’s say you have three credit cards and the total credit limit is $3,000. If you’ve charged up $2,000 across the board, your credit utilization ratio is about 67%.
By helping you pay off debt faster
One other obvious way to improve your credit score is to pay down your debt. Using a personal loan to eliminate high-interest debt in one fell swoop might help you do that faster — if you secure a loan that has a lower interest rate. Let’s pretend your debt looks like this:
- Credit card No. 1: $1,500 balance with $50 minimum payment and 18% APR
- Credit card No. 2: $3,000 balance with $100 minimum payment and 15% APR
- Credit card No. 3: $1,000 balance with $60 minimum payment and 17% APR
Let’s assume you can only afford to pay the minimum payment each month on your credit cards. You’ll pay less and get debt-free faster if you opt for a three-year $5,500 personal loan with 10% APR:
|Original credit card payments||New personal loan|
|Total interest paid||$1,441||$889|
|Timeline to get debt-free||41 months||36 months|
By providing a more affordable borrowing option
In 2017, four in 10 Americans said they wouldn’t be able to cover a $400 pop-up expense without selling something or borrowing money, according to a Federal Reserve Board report. If you fall into this camp, a personal loan may be your cheapest financing option, especially because average credit card APRs in late 2018 were around 16.9%. Maxing out your credit cards won’t just cost you more money (thanks to those high interest rates), it’ll also send your credit utilization ratio through the roof.
Of course, it all depends on your credit profile. Excellent credit generally opens the door for lower APRs, sometimes as low as 3.99%; not so if your credit score could use some work. In fact, the average APR for personal loans taken in 2018 was over 33.5%. This is why it’s so important to shop around. Comparing quotes online may reveal that a personal loan actually isn’t the best way to go. It depends on your financial big picture.
By giving you the opportunity to make on-time payments
The only thing more important to your FICO credit score than amounts owed is your payment history, which makes up about 35% of your score. Juggling multiple credit card payments means having to remember different payment due dates. And if you’re stuck in a high-interest debt cycle, a large chunk of your monthly payment is likely going toward interest.
A personal loan can offer one monthly payment with a fixed interest rate. This may take the headache out of budgeting, making it easier to keep up with regular on-time payments so you can prove to lenders that you know how to handle credit responsibly. A single late payment reported to the credit bureaus can stay on your credit report for seven years and drag your score down.
By diversifying your credit profile
“One nice thing about the personal loan is that it shows different types of credit, because one of the things that your credit score is also factored on is mix of credit,” said Opperman.
Credit mix actually makes up about 10% of your FICO Score, so having a diverse credit profile can be good. The idea is to responsibly handle a mix of credit — like credit cards, installment loans, retail accounts or a mortgage — to show that you can manage a variety of credit options.
How to get a personal loan
Many personal loans are unsecured, which means an asset isn’t used as collateral. As a result, interest rates tend to be a bit higher than with secured loans like a mortgage. The rate you get is determined in large part by your credit score. Generally, a lower score will mean higher financing costs.
That’s not to say it’s impossible to find a personal loan with below-average credit; it’s just that you might pay more for it. At the time of this writing, personal loan APRs varied from 3.99% to 35.99%.
LendingTree’s personal loan tool could make it easier to compare quotes online and shop for your best deal by filling out an online form. Based on your creditworthiness, you may be matched with up to five different loan offers from lenders. Opperman recommended comparing at least three different quotes. One thing that will affect the total cost is whether there’s an origination fee, which typically ranges from 0% to 6%.
Other ways to improve a poor credit score
If a personal loan isn’t in the cards for you right now, here are some other tried-and-true ways to boost your credit score.
Get a secured credit card
With a secured credit card, your payment history can be reported to the credit bureaus, so it’s a great way to build your score. Secured credit cards are different from traditional cards in that they require the cardholder to make an upfront deposit to open the credit line. You may get that money back after making timely payments for a set amount of time, usually eight to 12 months, depending on the issuer. Secured credit cards may come with additional fees.
“It’s really a great way to prove that you can handle a credit card and establish a credit score in the process,” said Opperman.
Credit builder loans, offered by many online lenders, credit unions and local banks, are another way to go. The bank makes a deposit for you, then you start making monthly payments. After a certain amount of time passes (generally six months to two years), you can unlock the funds.
Consider balance transfers
Balance transfers involve signing up for a credit card that has a low- or no-interest introductory period (usually 12 to 20 months), then transferring higher-interest credit card balances onto this new card. Most cards tack on a balance transfer fee, usually to the tune of 0% to 4%, but you’ll have that entire promotional period to pay it off with little or no interest.
Just bear in mind that applying for multiple cards at once should ding your credit score, so it pays to shop around before making a commitment.
Keep unused cards open
The length of your credit history accounts for about 15% of your FICO Score, so think carefully before closing out old accounts.
“Knowing that you’re not going to run those credit cards back up again, maybe you want to keep one or two of the older cards and put some type of recurring charge that you already have every month on them,” said Opperman. “It’s about using it in a modest way to preserve that length of credit history.”
Should you take out a personal loan?
Whether you should take out a personal loan really depends on your individual situation. No matter what, Opperman said the most important thing is having a plan. If you use a personal loan for debt consolidation, that means having the discipline not to charge up those credit cards again.
“Personal loans have the potential to save you thousands of dollars, and you don’t want to undermine that effort,” she said.
When in a financial pinch, personal loans can potentially be a powerful tool for boosting your credit score and putting yourself on solid ground.