How a Personal Loan Can Raise Your Credit Score by 20 Points or More
Most people who consolidate debt with a personal loan see their credit score go up -- here's why.
Can a personal loan raise your credit score? Several personal finance experts have said that it can, but now we have proof.
Credit bureau and consumer finance company TransUnion recently released a new study at the 2019 Money20/20 conference that examined consumers who used a personal loan to consolidate credit card debt. For 68% of those customers, the study found that their credit scores increased by 20 points or more within three months of consolidating their debt.
The results were even more impressive in subprime and near-prime consumers, where the study found 20-plus-point credit score improvement rates of 84% and 77%, respectively.
This may seem counterintuitive. After all, it is well known that applying for new credit (including a personal loan) can have a negative impact on your credit score. What's more, the study found that after consolidating credit card debt with a personal loan, the average consumer's overall debt actually increased. However, there are a few key ways that a personal loan can help your credit score far more than it could hurt it.
Lower credit utilization
One of the most important components of your credit score is the amount you owe -- or specifically, the amount you owe relative to your credit limits or to the original balances of your loans. In the FICO credit scoring formula, the "credit utilization" category makes up 30% of your score.
So, if you use a personal loan to consolidate all your credit card debts, the credit utilization on your credit cards effectively drops to zero. As long as you continue to keep your credit card accounts open (and keep your balances low), this is likely to be a major positive catalyst for your credit score.
Installment debt vs. revolving debt
There are two main categories of debts that are reported to the credit bureaus -- installment and revolving. Installment debts are loans with specified monthly payments which you pay off over a set amount of time. On the other hand, revolving debts are open ended and tend to have low minimum monthly payments and flexible repayment timeframes.
As you might guess, credit cards are revolving debts and personal loans are installment debts. And the latter is typically scored more favorably.
Think about it this way. If you have a credit card with a $5,000 limit and you have a balance of $4,900, that's a bad thing. Your credit card is nearly maxed out. On the other hand, a $5,000 personal loan that you've paid down to $4,900 isn't necessarily a bad thing at all.
One of the lesser-known components of the FICO credit-scoring formula is your "credit mix." This category accounts for 10% of your score, and you can think of it as a reward for diversification. For example, having a mortgage, a credit card, and an auto loan can be better than having three accounts of the same type.
The idea here is that lenders want to see that you can handle a variety of different types of credit responsibly, not just one or two. Adding a personal loan can help improve this score -- although the FICO® Score creators advise that this will likely have more of an impact on consumers with less established credit files.
This only applies to debt consolidation
Technically speaking, you can use a personal loan for whatever you want, even if the lender asks you to indicate why you're borrowing when you apply. And there are some ways that using a personal loan can be harmful to your credit score -- such as obtaining a personal loan on top of a mountain of credit card debt.
The point is that the score boost found in TransUnion's survey was specific to consumers who used personal loans to consolidate credit card debts and for no other reason. In a nutshell, when you do this, you're exchanging a bad form of debt for a good form of debt. But that isn't always the case when obtaining a personal loan.
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