You can improve your credit score with a personal loan -- but you shouldn't
Photo courtesy of Maui Kahiapo
Maui Kahiapo once posted an intriguing question on the social network Reddit that went something like this: If you took out a $1,000 personal loan and paid it off in 12 months, couldn't you boost your credit score? And wouldn't it be worth it -- even if you had to pay $100 or more interest?
The answers to these 2 questions are:
- Yes, you can improve your credit score by taking out a personal loan.
- No, in his case, it isn't worth it.
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How do you know a personal loan is for you?
By Jean Chatzky
While it's true that making the required monthly payment on the loan on time could positively impact your credit score, there are better -- cheaper -- ways to reach the same goal.
"You shouldn't have to pay to build your credit up. There may be other options out there outside of that," says Kathryn Bossler, a financial counselor with GreenPath Financial Wellness based in Farmington Hills, Michigan.
Indeed, Kahiapo, now 22, was looking to boost his score from the low 600s as quickly as possible. (He wants to refinance at a lower interest rate a car loan his mom took out for him.) "My thoughts were that if I could raise my credit and take on the loan myself, I would save money over the term of the loan," Kahiapo says.
No quick and easy route
But the Minneapolis resident soon learned from other online posters what personal finance experts routinely preach. There's no quick way to improve your credit score, but there is a reliable formula for success: Pay your bills on time every month and keep your credit utilization low.
What is credit utilization?
The amount of credit you use, versus how much credit has been extended to you.
"35% of your credit score is based on your payment history, the timeliness of your payments, the age of your accounts and how you manage those," says Bruce McClary, vice president of public relations and external affairs for the National Foundation for Credit Counseling, a Washington, D.C., nonprofit organization. "That's important to keep in mind, so you want to make sure you're focusing on the biggest piece of the pie."
Bossler says she tells clients you won't be rewarded with a big credit score increase with even the best financial behavior for at least 12 months. She says there's no fast lane: "It's something you have to establish over time."
What are the choices?
At the time Kahiapo was considering a personal loan, he already had one unsecured credit card with a $500 limit that he paid off monthly. As Reddit posters noted, he had other credit options to choose from that could prove cheaper than a personal loan, including:
- Applying for a 2nd unsecured credit card.
- Applying for a secured credit card.
- Asking his card issuer to increase his credit limit.
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Each of these options comes with a big caveat. Whenever you ask for additional credit, the issuer will run a credit check, which could cause a temporary decline in your credit score, McClary says.
And if you receive more credit, you should be careful using it. If paying off debt was a problem in the past, taking on new credit could be dangerous and lead to an even lower credit score. For example, a single missed payment can cause a huge drop in your score, McClary says.
"You should always embark on obtaining any kind of credit whether it's an increased limit or a new credit card with that plan in mind: How you're going to pay it back," says Diane Moogalian, vice president of operations for Equifax Personal Solutions, the credit bureau's credit monitoring and identity protection business unit.
What Kahiapo ended up doing
In the end, he decided not to take out a personal loan.
"Honestly, the community had so many alternatives that were more beneficial," he says. "Yes, I could have spent X amount of dollars on interest to gain a few points on my score. However, I wouldn't have learned and practiced things like my credit utilization so religiously. Not to mention it's quite literally giving away money."
Instead, Kahiapo focused on improving his financial habits:
- He put together a monthly budget that insured he would have enough money to pay his bills.
- He paid off his credit card debt.
- He made sure to keep his credit utilization low (10% of his available credit) by making credit card payments twice a month.
And about that credit score? Kahiapo has since raised it to 700.
"I've been able to increase it with good habits -- and time," he says.