I received a question from Maria M., who said, “I’m a new U.S. immigrant working hard to build good credit and make smart financial decisions. I’m so glad to find your Money Girl podcast because it’s helping me a lot. I have $8,000 in credit card debt and am considering paying it off with a three-year loan that would charge 16% APR. Would that be a good option for me, and how would it affect my credit score?”
Welcome to the U.S., and thank you for the great question, Maria! I’ll give you an answer on this show and discuss whether consolidating credit card debt with a personal loan helps or hurts your credit scores.
Why you need good credit scores
If you’ve been a short- or long-time listener to the Money Girl podcast, you already know that having excellent credit comes with terrific benefits. The higher your credit scores, the more lenders and merchants trust you. That means they charge you less interest for credit accounts–like credit cards, lines of credit, car loans, personal loans, private student loans, and mortgages–which reduces your monthly payment and saves a lot of money.
For example, getting a mortgage that charges 1% less saves $80,000 in interest on a 30-year, $350,000 loan! But even if you never borrow money, your credit affects many areas of your financial life.
For instance, having poor credit may cause you to get turned down by a prospective landlord for a place to live or an employer that you authorize to review your credit reports. In most states, having poor or average credit causes you to pay higher auto and home insurance premiums than policyholders with excellent scores.
Low credit scores mean you typically pay higher security deposits for utilities like power, gas, cable, internet, and wireless providers. Also, they may not extend promotional, money-saving offers based on your credit.
Remember that you must have credit accounts in your name and use them responsibly to have good credit. It’s a common misconception to believe that having no credit accounts means you automatically have good credit. That’s false because having no credit is the same as having bad credit.
If you have a “thin” credit file with no or little credit history, there’s no data for scoring models to calculate scores, which is problematic for businesses that want to see how you pay your bills. Without positive information in your credit files, lenders and merchants won’t choose to do business with you or will charge a premium for the potential risk you pose.
How multiple credit accounts affect your credit scores
So, how does opening up a personal loan to pay off a credit card affect your credit? First, let’s review how having a credit card improves your credit. I recommend that you have at least one credit card for the following benefits:
- Credit history – is how consistently you pay a credit account on time, which is the most significant credit scoring factor. Having credit cards you pay off in full each month is ideal for avoiding interest charges and showing lenders that you use credit responsibly.
However, if you carry a low balance and pay your card’s minimum payment on time, that significantly affects your scores. In other words, having at least one card is a way to demonstrate that you don’t miss payment deadlines.
- Credit utilization – is the amount of credit used, divided by your available credit limits on revolving accounts, such as credit cards and lines of credit. For example, a $500 balance on a card with a $1,000 limit is a 50% ratio.
Using a card only up to a low ratio, such as 20% to 25%, positively affects your credit. If you have a 50% ratio, paying down your balance will boost your scores. Low utilization is beneficial because it shows lenders that you only use the credit you need and don’t routinely max out cards or lines of credit.
Another way to decrease your ratio is to have more available credit by owning more than one credit card. Spreading out your balance over a larger amount of available credit is an easy way to reduce your utilization ratio and boost your scores.
- Credit mix – is the variety of credit accounts you own, such as installment loans (like an auto loan or mortgage) and revolving credit. Lenders like to see that you can manage different account types responsibly. That means having at least one credit card is essential for building your mix. Not everyone always needs an installment loan, but it’s easy to keep a credit card or two open in your name.
What are the best ways to use credit cards to improve your credit score? Money Girl Laura Adams explains how to use your cards more strategically. Listen in the player below.
I also want to acknowledge that opening new credit accounts can negatively affect your credit in the following ways:
- Credit age – is the average length of time you’ve had credit accounts open in your name. A more extended history of accounts positively affects your credit scores since it gives insight into your long-term financial behavior.
Opening a new card or loan reduces your average account age–however, the benefits of having the account can outweigh the downsides by boosting your scores when managed responsibly. - Credit inquiries – are notifications on your credit reports that you applied for a new credit account. Hard inquiries (as opposed to soft inquiries, like pulling your own credit reports) temporarily lower your scores slightly. Again, the benefits of a new card outweigh this negative mark in the long run.
- Credit amount – is your outstanding debt balance, which rises when you take out a new loan or make card charges. As I previously mentioned, having more revolving debt results in a higher utilization ratio, negatively affecting your credit scores. In addition, if you carry card balances, you’re paying unnecessary high interest charges.
Should you fill your wallet with credit cards or limit the number you have? It all depends on how you use credit and what makes sense for your financial life. Laura explains how to use credit responsibly and determine what number of credit cards is right for you. Listen here:
How does consolidating credit card debt affect your credit?
Maria asked about getting a loan to pay off her $8,000 credit card balance, known as consolidation. You can save interest by paying off a high-rate card with a lower-rate personal loan. For instance, you pay less interest if your card charges 26% APR and you wipe it out using a 16% APR loan.
You can get a personal loan at most banks, credit unions, and online lenders. Your loan amount depends on your lender, income, and credit. Loan amounts for personal, unsecured loans usually range from $500 to $35,000, with a fixed interest rate and three- to ten-year repayment terms.
Personal loan lenders typically charge an origination fee ranging from 1% to 10% of the loan amount, which gets deducted from your loan proceeds. Once approved, you receive the loan funds in your bank account within days and begin making scheduled monthly payments. Maria, here are several pros for using a personal loan to consolidate your credit card debt.
- Paying less interest: Cutting your interest rate is a primary reason to wipe out a card with a personal loan. Saving money on interest may allow you to get out of debt faster.
- Having a fixed term: Personal loans have a set interest rate and term, such as paying 9% for three years with monthly payments of $750. That can help you pay off debt faster–but only if the repayment term is affordable. Generally, the shorter a loan term, the higher your monthly payment will be.
- Having one payment: Maria didn’t mention having more than one credit card. But consolidating multiple cards with a personal loan can simplify your financial life by only having to keep track of one bill due date instead of several.
- Building credit: Having an additional loan on your credit report helps you build credit when you make timely payments. Plus, paying off or reducing high card balances lowers your credit utilization and increases your credit mix, helping your credit scores.
But consolidating a card comes with several downsides, too.
- Paying higher monthly payments: Depending on your personal loan amount, rate, and term, the payments can be higher than your card’s minimum payment. If you’re unable to make a loan payment on time, you can hurt your credit.
- Continuing to make card charges: Taking out a consolidation loan should be part of a bigger plan to pay off debt. If you use a personal loan to wipe out cards but rack them up again, you’re deeper in debt. A clean card can be tempting! So, Maria, you should be committed to only making charges you can pay off each month.
- Not saving enough interest: If your credit card debt is relatively small or you could pay it off within the next 12 months by tightening your budget, consolidation may not save you enough to be worthwhile. If you can pay off a card soon but want less interest, shop for balance transfer credit cards that charge 0% interest for a promotional period, such as 12 to 18 months.
- Temporarily hurting your credit: As I mentioned, every hard credit inquiry slightly dings your scores. That could be detrimental if you plan a big purchase within six months, such as a home or car. Try not to apply for other credit accounts ahead of a large purchase so you protect your scores. (Learn More at 9 Diagrams of the balance transfer credit card)
Maria, consolidating a credit card using a personal loan may be wise if you save money on interest, can afford the monthly payments, and aren’t planning a large purchase soon. Opening a new credit account does dip your credit temporarily, but it increases your credit mix and scores over the long run.
However, once you pay off a credit card, it’s best for your credit to keep it open (even if you don’t plan to use it) to preserve your credit limit. Closing a paid-off card shrinks your available credit instantly, causing your credit utilization to spike and your scores to dip.
Money Girl Laura Adams explains what you need to consider before closing an account, how to minimize hits to your credit, and tips for canceling cards strategically. Listen in the following player:
Any time your revolving balances become a higher percentage of your available credit, you appear riskier to creditors, even if you aren’t. So, keep your cards open and active, especially if a big purchase could be on the horizon. For instance, you could make small charges and pay off your card periodically, such as a few times a year.
If you have a card you don’t like because it has a high annual fee or APR, you could cancel it and replace it with another card, ideally before canceling the first one. That allows you to swap out one credit limit for another and avoid a significant increase in your credit utilization ratio.
This article originally appeared on QuickandDirtyTips.com and was syndicated by MediaFeed.org.
5 key differences between credit scores & credit reports
Credit scores have become synonymous with credit reports over the years, but there are some key differences you should know about. For one thing, you might be surprised to find upon reviewing your free credit reports that you won’t see your credit scores on them. Here’s more of what you need to know about the differences between credit scores and credit reports.
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The first thing you should understand about the differences between credit reports and credit scores is that they are two different products
Credit reports are generated by credit reporting agencies, also known as credit reporting bureaus or credit reporting companies. There are three credit reporting agencies: Equifax, Experian, and TransUnion.
Credit scores, on the other hand, are created by credit scoring companies. The two main credit scoring companies are FICO® and VantageScore®.
The lines between the two different types of companies are blurring, though, as they can partner together. (For example, Equifax, Experian, and TransUnion® all worked together to develop VantageScore®, even though it’s an independently run company. The companies also can create their own independent credit scores.) But more on that later.
In the meantime, what you need to know is that credit scores and credit reports are not the same, and you shouldn’t expect to see one of your credit scores when you obtain one of your free credit reports.
DepositPhotos.com
You can probably already surmise that you don’t just have one credit report and you don’t have just one credit score. The very fact that there is more than one company for each should make that clear. However, you might be surprised to know just how many of each you have.
Credit reports are simple to number. There are three major credit reporting agencies — therefore everyone has three credit reports. There are also companies that track your banking behavior and create reports on those, but those reports are not the same as your credit reports.
Tracking the number of credit scores you might have, on the other hand, is a bit more complicated. Although there are two major credit scoring companies, each one has multiple models of their scores. For example, FICO® has specific credit scores for auto loans as well as specific credit scores for mortgages and other types of credit.
What’s more, as FICO® and VantageScore® update their models, lenders using them don’t always update things on their end. Thus, several models of the same credit score can be in rotation at the same time, making it that much harder to know what score a specific lender might see when running your application for credit.
The main takeaway to understand here is that everyone has multiple credit reports and multiple credit scores, so seeing one doesn’t mean you’ve seen them all. The good news is, credit scores are put into ranges, so if you focus on the range instead of the number, you can have a fairly good idea of the current state of your credit.
DepositPhotos.com
There’s a number of ways to see your credit reports, but when you obtain your free annual credit reports from AnnualCreditReport.com, you won’t see your credit scores on them.
However, some services enable you to see one of your credit scores for free, and from which you can also review items that are on one of your credit reports. For example, if you sign up for Upturn, you can see both your VantageScore 3.0 from TransUnion® and individual cards showing each item that’s on your TransUnion® credit report.
You can also pay to see both a version of your credit score and a version of your credit report at the same time. FICO®, Equifax, Experian, and TransUnion® all have products that you can pay for to view one of your credit scores as well as items from one or more of your credit reports (along with other services, such as alerts to changes on the scores and reports they’re showing you).
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Credit scores and credit reports may be two different products, but that doesn’t mean they don’t relate to one another. In fact, the information on your credit reports will help to determine your credit scores.
When you pull up your credit reports, you’ll see specific information on each financial account you hold. That information includes your balances, your payment history, the length of time you’ve had those accounts, and so on. All of these heavily influence your credit scores.
The information above can be derived from your credit reports, which is why it’s so important to review them and ensure their accuracy regularly.
Johnny Greig/istockphoto
So, what can you do if your credit reports aren’t accurate? You can dispute them. Unfortunately, you can’t dispute your credit scores — but getting your credit reports corrected will affect change on your credit scores. Remember, they’re different products, but the information on your credit reports will be used to determine your credit scores.
If you see a mistake on your credit reports, you can dispute the mistake through the credit reporting agency showing that mistake. You can also use free tools from different companies (including Upturn, which helps you find and dispute mistakes on your TransUnion® credit report).
Once the dispute is resolved and a change is made to the credit report in question, then your credit scores should reflect that change, though not necessarily right away.
This article originally appeared on UpturnCredit.com and was syndicated by MediaFeed.org.
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Featured Image Credit: DepositPhotos.com.
