Obtaining a personal loan can be a great way to improve your credit score in certain situations, but it is not always the right choice. Taking on any debt always brings with it a substantial amount of risk, and the decision should never be made lightly.
How a personal loan can improve your credit score
Before you decide whether a personal loan makes sense for you, you need to understand the way it works. A personal loan is a way of consolidating your credit card debt. In general, a personal loan has far lower interest rates than credit cards have, so when you roll your debt into a personal loan and use it to pay off the debt on your cards, you save money. LendingClub reported that its borrowers of personal loans pay 35 percent lower rates on their loans than they were paying on outstanding debts or credit cards.
As explained in Market Watch, credit card debt is more detrimental to your credit score than debt accrued from taking out a loan, which is known as installment debt. Therefore, it can sometimes be beneficial to take on more installment debt if it means reducing your credit card debt. When you take out a personal loan to pay off your credit cards, you are in a sense shifting from credit card to installment debt. John Ulzheimer, a consumer credit expert at CreditSesame.com and a former manager at FICO, told MarketWatch that this shift could improve your credit score by 100 or more points.
Forbes contributor Nick Clements emphasized the fact that you should never take out a personal loan if you are not already in debt. It is unnecessary to go into debt to improve your score. Obtaining a credit card and paying off the balance in full every month is a great way to build good credit, so don’t think that paying interest rates on a loan is the only way. The reason personal loans can so significantly improve a credit score is because they help borrowers pay off their debt. If you don’t have debt, a loan is probably not necessary.
When is a personal loan the right choice?
A personal loan is a good option for those who have already accumulated a significant amount of credit card debt. NerdWallet, a financial education website, said to take out a personal loan when you are determined to pay off your debt and don’t think you can manage it on your own. If you think you can pay it off within a year, you probably don’t need a personal loan. You also need to have pretty good credit to qualify for a personal loan. They exist for someone with a good score who wants to make it better. If you have a truly low score and can’t manage your debt, Nerd Wallet recommended seeking expert advice and considering bankruptcy as an option.
Credit unions, banks and online lenders offer personal loans. As you shop around, CreditSesame.com said to beware of those lenders who may consider your rate inquiry as a hard inquiry — as too many of those could really hurt your score. However, there are ways to compare rates without making hard inquiries. Some lenders are willing to provide estimates over the phone if you know your credit score and some will do soft inquiries for those who have been preapproved or prequalified.