It seems unlikely and initially it may even appear stupid. You may question why you should take out a personal loan to help improve your credit rating. Surely that would just increase the likelihood of credit score becoming even worse.
To help resolve this seemingly counter-intuitive position of taking a loan to boost your credit rating, we need to look at how your credit rating is scored:
When you take out a personal loan, it will have an immediate impact on three of the factors – two positive (Payment History – if you pay your way/Credit History if you keep your accounts) and one negative against Credit History if you immediately cancel any credit lines.
Also, New Credit may show a blip to start with – but this is a small component and temporary.
It won’t immediately impact your payment history until after you start making payments. Your credit score will improve over time as long as you make on time payments on the loan.
It won’t have a big positive affect on the length of credit history factor until it has been in place for some time, however, because it is based on the average age of all your credit accounts, it could have a negative impact on your score at first. It will certainly hurt your score if you CANCEL ANY of your credit cards, but overall, with a 15% weighting, it will be negligible.
Whilst there are some risks associated with taking out a personal loan with a bad credit rating – especially if you do not have the resources to pay back the loan – there can be benefits also to securing additional funds in this way. Having more lines of debt will harm your rating at first, but don’t worry, this will diminish over time and will be rewarding ultimately, should you make your repayments every month.
Ideally, we should all have an emergency fund, or at least some savings for when financial emergencies crop up. But for the majority this just isn’t feasible. The reality is that most people do not have that pot of gold ready for such difficulties and need to borrow to cover such unexpected costs. This borrowing may be in the form of a loan, or a line of credit to access the funds needed. So, with this regular situation in our modern world, why wouldn’t we try to gain something from the experience, such as boosting our credit rating with that necessary loan, which we will repay over time.
How do I choose between a Line of Credit and a Personal Loan to boost my credit rating?
What is A Personal Loan?
A personal loan is an instalment loan with a fixed interest rate and loan term. When you take out a personal loan, you are given the amount in a lump sum, and you make regular, fixed payments every month for a set period of time. Personal loans are usually unsecured: they do not require any form of collateral (a Surety or Guarantee).
What is A Line of Credit?
A line of credit works differently. With this type of credit, you are given a revolving account where you can withdraw a certain amount of money, repay it (with interest, of course) then withdraw funds again when necessary.
Your credit card is the best example of this line of credit; although you are most used to returning home with something tangible, the money for it is required back at some point and the interest keeps rising without regular payments by your due date each month.
If you take the time to research both avenues of:
1) a line of credit and
2) a one-time personal loan,
you may begin to think it could make sense to take out a personal loan to improve your credit rating.
Here are the reasons why:
For many of us, the difference between the two is that psychologically it’s easier to get into a spiral of debt with a credit card, as you can carry on spending on the card (up to what is, sometimes, a limit of thousands) without realising the debt you are building up.
A credit card feels like free money; whereas a loan is a definitive amount of money which you know you have to repay, generally with an agreed payment plan. This should make you more aware of the necessity to keep up your set, regular payments and therefore your credit rating will improve.
It could even make sense to take out a personal loan, should you wish for instance, to pay off a credit card bill in order to prolong and improve your credit rating. You do not have to cancel your card if you pay it off.
Let’s look at that scenario:
With 30% weighting, Debt-to-Credit Limit is a major component of your credit score. It’s based on how much credit you are utilising in relation to your available credit. To improve your credit score, you would need to reduce your credit utilisation ratio to below 30%.
For example: If your credit limit on your cards is £10,000 and you have an outstanding balance of £7,000, your credit utilisation ratio is 70%. If you were to reduce it to below 30% that would immediately boost your credit score. Replacing the £7,000 credit card balance with a personal loan would drop your credit utilisation to 0%.