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Have you been making payments on your credit card debt to try to improve your credit score only to see it stalled?
It may sound ridiculous, at the very least it’s counterintuitive, but taking out a personal to improve your credit score could be a thing. Before going out and taking on a personal loan, let us explain exactly what we mean.
What is a Personal Loan?
Typically, a personal loan is an unsecured loan, meaning it is not secured by underlying collateral. The lender relies on your good credit and stable employment in approving a personal loan, which can be issued for varying amounts depending on the lender. Most personal loans are issued with fixed interest rates and one to three year terms.
If you have good credit, you can typically qualify for personal loans with lower rates than credit cards. Under the right circumstances, you can replace your credit card debt with a personal loan and increase your credit score in the process. Here’s how that might work.
How Your Credit Score Could Be Impacted By a Personal Loan
Under these circumstances, it is important to ask yourself, does a personal loan hurt your credit? Your credit score is calculated based on five factors, which are weighted according to their importance in the scoring.
- Payment history (35%): Scores your payment history – on time payments are good; late payments are bad
- Debt to credit limit (Credit Utilization Ratio) (30%): Scores your credit utilization
- Length of credit history (15%): Scores the age of your credit accounts; older accounts are better
- New credit (10%): Scores your tendency to take on new debt as measured by new credit inquiries
- Credit Mix (10%): Scores the mix of your credit
When you take out a personal loan, it will have an immediate impact on three of the factors – two positive and one negative. It won’t immediately impact your payment history until after you start making payments. Your credit score will improve over time as long as you make on time payments on the loan.
It won’t have a big affect on the length of credit history factor until it has been around for awhile; however, because this component is based on the average age of all your credit accounts, it could have a negative impact on your score at first. It will certainly hurt your score if you cancel any of your credit cards, but with a 15 percent weighting it will be negligible.
A new personal loan could have an immediate impact on the three other factors in the following ways:
With a 30 percent weighting, this is a major component of your credit score. It’s based on how much credit you are utilizing in relation to your available credit. To improve your credit score, you would need to reduce your credit utilization ratio to below 30 percent. So, for example, if the total credit limit on your credit cards is $10,000 and you have an outstanding balance of $7,000, your credit utilization ratio is 70 percent. If you were to reduce it to below 30 percent, that would immediately boost your credit score.
If you replace the $7,000 credit card balance with a personal loan, your credit utilization ratio would drop to 0 percent. The personal loan balance would not impact your credit utilization because it is treated differently than credit card debt.
Credit cards are revolving accounts, which means your debt balance goes up and down based on their use and your payments. Personal loans are considered to be installment loans, with set loan balances and repayment periods. So the same amount of debt on a personal loan is not considered to be as detrimental as if it were carried on your credit card accounts.
The big danger here is all the newly available credit on your credit cards, if you start charging up the balances. That could hurt your credit score along with your chances of qualifying for new credit.
Any time you apply for new credit, the credit bureaus look at it as an increased risk. So merely by applying for a personal loan, an inquiry will be reported to the credit bureaus, which will ding your credit score. Fortunately, the ding is relatively small (10 percent weighting) and temporary.
You definitely want to avoid multiple inquiries within a short period of time, because each one carries the same weighting. Before applying for a personal loan, make sure you can qualify based on your credit.
In scoring your credit, the credit bureaus want to see how well you manage credit and whether you have a good mix of credit. Over-relying on one type of credit, like credit cards, is perceived as a risk. By adding an installment loan to your credit profile you add to your mix, which could be good for your score.
So yes, taking out a personal loan can potentially increase your credit score. But it needs to be done carefully with a deliberate plan to continue paying down your debt, or you could potentially compound your problem and do more damage to your score.
If you are seriously considering this approach, you should make sure you fully understand how personal loans work.
Author: Jeff Gitlen