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 increase your credit score.
This is what you need to know and how it works.
What is a Personal Loan?
A personal loan is an unsecured loan typically of $ 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 collateral attached to the loan.
For example, if you mortgage your home, your mortgage is a “safe” loan in which your home is the guarantee. If you fail 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 taking more risks.
However, interest rates on personal loans are often much lower than the interest rates on credit cards, which usually range from 10-20% (or higher).
Depending on your credit profile, you may be able to qualify for a low interest 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 financial liability history, 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 pay 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 for getting a personal loan.
You can use a personal loan for debt consolidation in two main ways:
Pay existing high interest debt with a low interest personal loan
Combine existing multiple debt obligations into a single personal loan to make payment of debt more organized and manageable
You can use a personal loan to consolidate high interest credit card debt and get a lower interest rate to help pay off your debt more quickly.
Of course, that assumes that you will take advantage of the lower interest rate and the lower monthly payments to speed up your credit card pay off.
However, if you plan to kick the can along the way and not develop a plan of action to pay off your debt, then you may want to evaluate other options.
So, use a personal loan to pay off 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 of all, you need to compare the interest rate of your credit card with the personal loan interest rate to determine what interest rate is lower.
If you have a strong or excellent credit and an existing credit card debt, you should be able to get an interest rate lower than the current interest rate of your credit card.
Secondly, you need to understand that if you qualify for a lower interest rate, how old will you have to pay your personal loan as compared to your credit card debt and if you are comfortable with the repayment period.
Having a shorter repayment period for loans can not only save you interest costs, but also instill discipline to withdraw your debt more quickly.
For example, if you have $ 10,000 of credit card debt at 15% interest and you can get a personal loan with 7% interest (depending on your credit profile and other factors), you could reduce your interest payments on More than 50%.
Self-reflection: how and why this debt was acquired
When you consolidate your debt, you should reflect on how and why you acquired this debt.
Understanding how and why are even more important than lowering the interest rate with a personal loan.
Are you spending too much?
Are you making too many impulse purchases?
Do you need more income to support your expenses, or can you simply reduce spending?
Creating a monthly budget to track 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 a 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 loan is usually a lower cost option. However, unlike a personal loan, a home equity loan is a secured loan so that it means that your home serves as collateral and can be claimed by the lender if you do not pay the debt.
How a Personal Loan Can Improve Your Credit Score
Lenders evaluate the use of your credit card, or the relationship between your credit limit and spending in a given month.
If your credit utilization is too high, lenders may consider it a higher risk.
The use of the credit is reported to the credit bureaus on a monthly basis at the 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 usage:
- Set up automatic balance alerts
- Ask your lender to increase your credit limit (this may involve a hard credit flip so check with your lender first)
- Instead of paying 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 the use of credit.
For example, you can improve your credit score by replacing credit card debt with a personal loan.
Why? A personal loan is an installment loan, which means that a personal loan carries a fixed repayment term. Credit cards, however, are revolving loans and have no fixed payment term.
Therefore, when you change credit card debt for a personal loan, you can reduce your credit utilization and also diversify your debt types.
2. Medical expenses
If you have a medical emergency or unexpected medical expense and can not pay the full cost in advance, a personal loan may be a better solution than a credit card.
Often, you may qualify for a larger loan amount with a personal loan than a credit card, which may be necessary for your health expenses.
3. Emergency Home Repair Or Home Improvement
If you need to complete an emergency repair in your home or a small home improvement project, and you can not take a mortgage loan, access a line of credit or refinance your mortgage, then a personal loan can be an attractive option.
A personal loan can make good financial sense for a home renovation project if the renovation improves the financial value of your home (and the cost of borrowing the personal loan is less than the expected appreciation of your home as a result of the project renewal).
4. Other Uses for a Personal Loan
A personal loan can be used to help pay for other key life events, including an engagement ring, wedding, moving, honeymoon and many other uses.
Like any debt obligation, ask yourself if your reason for getting a personal loan is a “wish” or a “need.”
For example, if you are planning to get married and do not have the financial resources to pay for your wedding, then your best bet is to consider a smaller wedding and find ways to reduce costs without borrowing.
If that is not feasible, then a personal loan could save you interest costs compared to a credit card. Important, make sure you can repay the loan at the end of the loan term.
A personal loan, therefore, should not be an excuse to acquire more debt.
Rather, a personal loan can be a useful tool for the smart borrower who has a plan of action to get free debt and march down the road to financial freedom.