Is it possible for a loan to improve your credit score?
After all, a loan typically means more debt.
When you use a personal loan to consolidate debt, however, you may be able to boost your credit score.
Here’s what you need to know and how it works.
What Is A Personal Loan?
A personal loan is an unsecured loan typically from $1,000 – $100,000 with fixed or variable interest rates that can be used to consolidate debt or make a large purchase.
The term “unsecured” means that there is no underlying collateral attached to the loan.
For example, if you borrow a mortgage for your house, your mortgage is a “secured” loan in which your home is the collateral. If you default on your mortgage, your lender will then own your home.
The interest rate on an unsecured loan such as a personal loan is higher than the interest rate on a secured loan such as a mortgage because the lender is assuming more risk.
However, interest rates on personal loans are often much lower than the interest rates on credit cards, which typically range from 10-20% (or higher).
Depending on your credit profile, you may be able to qualify for a low-interest rate personal loan and save money compared to a credit card.
The interest rate on your personal loan will depend on several factors, which may include your credit score, credit history and debt-to-income ratio.
The stronger your credit profile and history of financial responsibility, the lower the interest rate you can expect.
When Should You Use A Personal Loan?
Personal loans are best for purchases that you plan to repay in less than five years.
Unlike student loans or mortgages that are spent on specific purchases such as education or a home, respectively, personal loans can be spent at your discretion.
Therefore, you have more flexibility and personal choice when using a personal loan.
1. Debt Consolidation
Debt consolidation is one of the most popular – and smarter – reasons to obtain a personal loan.
You can use a personal loan for debt consolidation in two primary ways:
- Pay off existing high-interest debt with a lower-interest personal loan
- Combine existing, multiple debt obligations into a single personal loan to make debt repayment more organized and manageable
You can use a personal loan to consolidate high-interest credit card debt, and obtain a lower interest rate to help pay off your debt faster.
Of course, that assumes you will take advantage of the lower interest rate and lower monthly payments to accelerate your credit card pay off.
However, if you plan to kick the can down the road and not develop an action plan to repay your debt, then you may want to evaluate other options.
Therefore, use a personal loan to repay credit card debt and become debt-free. Do not use a personal loan as a tool to postpone debt repayment.
How A Personal Loan Can Cut Your Credit Card Interest By 50%
First, you need to compare the interest rate on your credit card with the interest rate on the personal loan to determine which interest rate is lower.
If you have strong or excellent credit, and existing credit card debt, you should be able to obtain an interest rate lower than your current credit card interest rate.
Second, you need to understand that if you do qualify for a lower interest rate, how many years you will have to repay your personal loan compared with your credit card debt and whether you are comfortable with the repayment period.
Having a shorter-term loan repayment period can not only save you interest costs, but also instill discipline to retire your debt more quickly.
For example, if you have $10,000 of credit card debt at 15% interest and can obtain a personal loan at 7% interest (depending on your credit profile and other factors), you could potentially cut your interest payments by more than 50%.
Self-Reflection: How And Why You Acquired This Debt
When you consolidate your debt, you should reflect on how and why you acquired this debt.
Understanding the how’s and why’s are even more important than lowering the interest rate with a personal loan.
- Are you over-spending?
- Are you making too many impulse purchases?
- Do you need more income to support your spending, or can you just reduce the spending?
Creating a monthly budget to monitor your income and expenses will help you better manage your monthly cash flow.
Are There Alternatives To A Personal Loan?
There are several alternatives. For example, if you have strong or excellent credit and plan to pay-off your existing credit card debt in 12 months, you could use a credit card with 0% interest balance transfer.
If you own your home, a home equity loan is usually a lower cost option. However, unlike a personal loan, a home equity loan is a secured loan so that means your home serves as collateral and can be claimed by the lender if you do not repay the debt.
How A Personal Loan Can Improve Your Credit Score
Lenders evaluate your credit card utilization, or the relationship between your credit limit and spending in a given month.
If your credit utilization is too high, lenders may consider you higher risk.
Credit utilization is reported to the credit bureaus monthly at your closing date. Therefore, anything you can do to reduce your balance during the month before your closing date will help improve your credit score.
Here are some ways to manage your credit card utilization:
- set up automatic balance alerts
- ask your lender to raise your credit limit (this may involve a hard credit pull so check with your lender first)
- rather than pay your balance with a single payment at the end of the month, make multiple payments throughout the month
You can also use a personal loan to help with credit utilization.
For example, you may improve your credit score if you replace credit card debt with a personal loan.
Why? A personal loan is an installment loan, which means a personal loan carries a fixed repayment term. Credit cards, however, are revolving loans and have no fixed repayment term.
Therefore, when you swap credit card debt for a personal loan, you can lower your credit utilization and also diversify your debt types.
When consumers face a personal financial crisis, they tend to prioritize unsecured personal debts ahead of mortgages, credit cards and car loans, a new study has found.
The study was conducted by TransUnion, which has analyzed customers’ payment hierarchy since 2010. This study was the first time the credit reporting agency incorporated unsecured personal loans into its accounting.
“It is quite surprising to us that, for most struggling consumers, unsecured personal loan payments are prioritized over other prominent credit products such as mortgages and auto loans,” said Ezra Becker, senior vice president and head of research for TransUnion’s financial services business unit. “While personal loans have existed for a long time, recent growth in the number of such loans led us to explore this product’s position along the payment spectrum. The prioritization of personal loan payments above all others is counterintuitive, but our study results are clear. We believe the relatively short duration of these loans—usually less than 30 months—is a key factor in the decision process of consumers.”
Personal loans usually had a much shorter term than secured debt like mortgages and auto loans – on average, less than 30 months, compared to 60 months for auto loans and 230 for mortgages.
“We conjecture that personal-loan borrowers may feel they can get a quick win with these loans even when they are struggling, and there is a clear, near-term end to the obligation – a ‘light at the end of the tunnel,’ in a sense,” Becker said. “In contrast, auto loans and mortgages have much longer terms, and credit cards have no set end date. Finding an opportunity to pay a debt in full can be a powerful motivator for a struggling consumer.”
Personal loans have also historically had a much lower delinquency rate than other kinds of debt, TransUnion found. However, personal loan delinquencies have been trending upward over the last few years while delinquencies on mortgages, auto loans and credit cards have generally trended down.
When you’re facing a large, one-time expense and don’t have the cash on hand to pay it, taking out a personal loan could be an attractive option.
How Personal Loans Work
Personal loans are unsecured, meaning that they aren’t backed by collateral. By contrast, a home mortgage is secured by your home, and a car loan is backed by your car. If worse comes to worse and you fail to repay those types of loans, the lender knows it has an asset it can try to seize and sell.
By contrast, your eligibility for a personal loan is likely to be determined by your credit score from one of major credit bureaus, as well as such factors as your employment history, income, and debt-to-income ratio.
Personal loans generally carry a fixed interest rate and require that you pay the lender back in monthly installments over a specific term, such as two to five years. Because no collateral is involved, the interest rates on personal loans tend to be higher than on many other types of borrowing.
The average interest rates on personal loans recently ranged from 10% to 32%. People with excellent credit scores (720-850) were likely to be able to obtain loans with average annual percentage rates of 10% to 12.5%, while those with poor credit scores (300-639) faced average APRs of 28.5% to 32%.
If you’re eligible for a low-rate personal loan, you might also consider using one to pay off other, higher-interest debts, such as credit card balances. But bear in mind that the personal loan will have to be paid off in its entirety by a certain date, while your credit cards do not. The federal Consumer Financial Protection Bureau also cautions against debt consolidation loans that start off with low “teaser rates” that can shoot up after a period of time.
You’ll also want to be sure you know about any additional fees. For example, many lenders charge an origination fee of 1% to 6% of the loan. Others may impose a prepayment fee (otherwise known as an exit fee) if you want to pay your loan off early.
An alternative to a personal loan for paying off credit-card debt is a balance-transfer card. These allow you, usually for a fee of 3% of the balance, to transfer your card balance to a new card with a different bank that offers 0% APR for a specified period.
Where To Get a Personal Loan
The first place to go shopping for a personal loan is your local bank or credit union. If you already have a relationship there, you may have less trouble securing a loan. Credit unions, in particular, are known for their relatively reasonable interest rates.
Your next stop should be competing banks (and another credit union if you belong to more than one), to compare rates.
Online lenders are another possibility, but make sure you’re dealing with a legitimate one, as this field is rife with scam artists whose websites may look perfectly respectable. In fact, they may not be in the loan business at all but simply collecting personal financial information from unwary borrowers that they can use to commit identity theft.
To protect yourself, the Federal Deposit Insurance Corporation suggests checking with your state attorney general’s office or the state or local consumer affairs department to see if they have any complaints about a particular lender. The Better Business Bureau also has ratings on many lenders.