It’s understandable why you might be afraid to take out a personal loan even for the sake of getting a good credit score. The idea of being committed to a debt you will pay for some time might be overwhelming and alarming. That’s most true if you’re not confident with your current source of income, regardless of whether you’re a career or business person.
However, applying for a loan is sometimes necessary because there’s no other way to raise the funds you need for a particular reason. That reason might be to manage a high-interest debt, remodel your home, or pay for an emergency expense such as a trip to the hospital.
There are myths about loans that might discourage you from applying for one. Among those is how being in debt is always an unsound financial decision. However, what’s not often discussed is how there’s also an upside to taking out a personal loan. That is in terms of improving your credit score.
Credit Score in a Nutshell
Consider your credit score as your borrower’s identification. Loan providers use it to decide whether or not to grant your loan application. The FICO, a standard that the Fair Isaac Corporation established, is the most widely used credit rating. Under FICO’s system, credit scores range between 300 and 850.
FICO scores have five components. They are as follows:
- Payment history
- Length of credit history
- Amounts owed
- Credit mix
- New credit
You may refer to the following categories to assess where you’re at on the FICO score scale:
- Excellent: 720 to 850
- Good: 690 to 719
- Fair: 630 to 689
- Bad: 300 to 629
While it’s true that debt has a bearing on your FICO score, it doesn’t always lean on the negative. It all depends on how you manage a particular loan.
4 Ways a Personal Loan Might Improve Credit Score
Between one who has never applied for a loan and another who has and paid religiously, the former might have a less impressive credit score. That’s because a cleverly managed personal loan can boost your credit rating. Here’s how.
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Builds payment history
This is one of the most crucial factors for determining whether a borrower is creditworthy. It accounts for 35% of your FICO rating. By making timely payments, you steadily build a credit history that will eventually be enough to steer your FICO score in the right direction.
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Reduces credit utilization ratio
A high credit utilization ratio is one of the most notorious culprits for a bad credit rating. That happens when you consistently max out your credit limit.
If you use multiple credit cards at the same time, the more your credit utilization ratio will suffer. That’s most true if you’ve made it a habit to only pay the minimum required monthly payment instead of the total amount you owe.
If you’ve accumulated an enormous credit card debt that has raised your credit utilization ratio through the roof, a personal loan might be what you need to pull that back to 0%. Use the loan to pay your credit card debt in full.
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Diversifies credit mix
Credit ratings also look into how a borrower manages a diverse credit portfolio. For example, efficiently juggling an auto loan, student loan, and credit card debt will be much more impressive than paying only one type of loan.
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Pays off high-interest debt
If you apply for a personal loan to take care of a high-interest credit line, you’ll be doing your credit score a favor. However, keep in mind that exorbitant interest rates, fees, and penalties can quickly and exponentially increase what you originally owed.
Tips on How to Manage a Personal Loan
Remember the following hacks to better manage a personal loan in a way that benefits your credit score.
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Consolidate quickly
It’s a legitimate financial hack to apply for multiple loans to get the best terms. However, this might tip off credit raters, and your credit score might suffer for rate shopping. To minimize the negative impact of multiple loans on your credit rating, consolidate within a week of receiving the loans.
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Pay religiously
If your primary motivation for applying for a personal loan is to improve your credit score, the importance of sticking to the terms of the agreement cannot be stressed enough. Pay your monthly dues on time. Do not allow those penalties and interests to pile up and make it difficult for you to get out of the loan fast.
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Consider a credit-builder loan
This is a surefire way to improve your credit score without getting into debt. A credit builder loan is a product that doesn’t give you access to any funds. Instead, you agree to pay a fixed amount every month specifically to have those payments reflected in your credit history.
After the payment period, you get the funds. By then, you’re free to do whatever you want with it. You can spend it or tuck it away as an emergency fund. Either way, you’re no longer in debt. Basically, you enlisted the help of a third party to improve your credit history and save money at the same time.
Wrapping It Up
A bad credit score wreaks havoc on your financial plans. It might hinder you from investing in real estate, for example. Mortgage providers will not trust you with a long-term loan if your history as a borrower is far from exemplary. The same goes for car loan providers. You’ll find it difficult to take home the car you want if your credit rating paints you as an irresponsible debtor.
That’s why it pays to take your credit score seriously as you get your finances in order. First, pay your outstanding debts religiously. On top of that, you can also get behind the strategy of using a personal loan to improve your credit standing. Both of these tactics will work if you do them right.
Speaking of doing your finances right, consider having a financial advisor. They can guide you on how to best go about crucial money matters.