Millennials have debt on their minds. And it’s not just student loans.
Credit card debt is the most prevalent form of debt for millennials, according to a recent survey conducted by NBC News/GenForward.
Carrying high credit card balances also impacts your credit score. A portion of your credit score is calculated based on your debt-to-credit ratio. That means the more of your available credit you use, the lower your score will be. The fastest way to raise your credit score and improve your financial health is to pay down credit card debt.
Paying off credit card debt is no small feat, especially if your cards have high interest rates. Everyone’s situation is different, however, for some, a personal loan could be a good option with two positive effects: You can use a personal loan to pay down credit card debt and improve your credit score.
How personal loans work
Fifth Third offers personal loans between $2,000 and $50,000. Unlike a student loan, car loan or mortgage, these funds need not be used for a specific purchase. You can put the funds from a personal loan towards anything you want — such as consolidating credit card debt.
Typically the interest rate on a personal loan is significantly lower than most credit cards. As an example, let’s say you have a $7,000 balance on a credit card with a 15% interest rate. If you continue to carry that balance, the real cost of that debt is $8,050. If you take out a personal loan for $7,000 at a 10.49% interest rate, the total loan repayment is $7,734.40.
If you chip away at credit card debt over time, you’ll still need to pay that hefty interest rate. Or, you could get a personal loan, wipe out or significantly reduce the credit card debt, then make payments towards your personal loan at a lower interest rate.
Unlike credit cards, personal loans also offer predictability and set monthly payments. Your terms and payment amount are set up front, so you’ll know exactly what you need to pay every month until the loan is paid off. Credit cards offer so much flexibility that for some people it’s easy to overspend, miss payments or carry high balances, leading to a lower credit score.
Leveraging a personal loan to improve your credit score
A personal loan won’t instantly improve your credit score. Your credit score will likely drop a few points at first because you’re taking on new debt. But it's good to remember that credit scores are not stagnant numbers. Your credit score changes month to month. Depending on how much you borrow and repay in a given month, it could change by a few points or by several.
Over time, your score will begin to climb — granted that you put the funds towards paying off your credit cards, make on-time loan payments and do not take on more credit card debt along the way.
Here are three ways a personal loan can positively impact your credit score.
Increase history of on-time payments
Once you begin to make payments on your loan and consistently do so over the lifetime of the loan, your credit score will begin to improve. On-time payments weigh the most heavily in your credit score. To ensure you make every payment, set up payments to be automatically deducted from your checking account.
Diversify your mix of credit
Your credit score takes into consideration the different types of debt you carry. Lenders like to see you can responsibly use a variety of credit types, not just credit cards. Adding a personal loan to the mix makes for a stronger credit score.
Lower your credit utilization ratio
Debt-to-credit ratio is another important factor in how credit bureaus calculate your score. Simply put, the less of your available credit you use, the better for your credit score.
A personal loan does two things. Firstly, it increases the amount of credit you have available to you. And secondly, by using that loan to consolidate credit card balances, you also reduce your credit utilization ratio on your existing cards. Over time as you pay off your loan balance, you’ll further reduce your debt — meaning good things for your credit score.
Keep your credit score climbing
As you work towards repaying your loan in full, it’s important to stay on top of payments. A late or missed payment will negatively impact your score. Keeping your existing cards active and open may also help because length of credit history impacts your score. Just be careful not to rack up balances you can’t pay off. The goal is to pay off credit card debt, not make more of it.