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 3-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.
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.