Consolidating credit card debt with a personal loan can do more than help you save money and budget better. It may also help your credit scores. Here’s how:
Free Up Available Credit
One of the factors that can affect your credit scores is the ratio of outstanding balances to available credit on your revolving lines of credit. As your balances on revolving accounts (usually credit cards) get closer to their credit limits, your credit scores may go down.
Personal loans, however, are usually installment loans; in other words, loans for specific amounts with set repayment periods. They are treated differently than revolving accounts within most scoring models; i.e., the same amount of debt on an installment loan may not be as detrimental to your credit scores as the same amount carried on a credit card that’s near its limit.
By consolidating credit card debt with a personal loan you may improve this “debt-to-available credit” ratio. This ratio — called the “utilization ratio” in industry lingo — accounts for almost 30% of your credit scores, so the difference can be dramatic if credit card debt has been dragging down your scores.
Improve Your Mix of Credit
Consumers who earn the highest credit scores typically use a mix of different types of credit, including both revolving and installment loans. If your credit reports show mostly credit cards but few installment loans, you may be losing points for this factor. A personal loan is one of the types of installment loans that can be helpful here. Other types include mortgages, auto loans, or student loans.
Reduce Debt Faster
Personal loans often feature three-year repayment plans. While you can design a payment plan to retire your credit card balances in 36 months yourself, let’s face it. It’s easy to fall off the wagon when money’s tight. But with a personal loan, you won’t have a choice. After all, the low minimum payments that let you stretch your debt out for decades on credit cards simply aren’t available on these loans.
Don’t Be Fooled
There can be a downside to this debt consolidation strategy if you are not careful. First, keep in mind that when you take out a new loan, your credit scores may take a dip because the new loan typically represents additional risk. Over time, that should even out, provided you make your payments on time and refrain from opening any other new accounts for as long as possible.
Also, when you pay off a credit card with a personal loan, you’ll want to keep the credit card open or you’ll lose some of the potential benefit to your credit. According to Barry Paperno, credit expert at Credit.com, if you close that card after paying it off, its credit limit and zero balance are removed from scoring calculations that look at your overall credit utilization, and you may not see an increase in your credit scores after the payoff. On the other hand, should you leave it open, the card’s credit limit and zero balance will be included in your credit utilization calculations, resulting in a lower overall ratio (assuming you haven’t raised any other balances) and a higher credit score — but again, only if the paid off card remains open.
While you’re at it, use the card you’ve paid off from time to time so your card issuer doesn’t close it due to inactivity. Just charge something you’d buy anyway, such as a tank of gas, and pay the bill in full when it arrives.
Finally, don’t run up new debt on the credit cards you’ve paid off. After all, your goal here is to get out of debt, not to dig the hole deeper.