Will paying off my credit card debt with a personal loan improve my credit score?
I'm considering paying off three credit cards (two of which have balances very close to their credit limits) with a personal loan. If I do this, will my credit score improve even though I'll still be in debt?
Joshua Escalante Troesh was voted the #1 advisor nationally by the Advisor Insights audience.*
Yes, paying off credit card debt with a personal loan will in fact improve your credit score, but you should avoid making this decision based on the impact to your score. Your score is calculated based on a number of factors, and this change will impact two of them; Capacity and Mix of Credit.
How The Strategy Helps
Your capacity is determined by the amount of revolving debt (like credit cards) you have divided by the total limits you have on the revolving debt. By paying off the credit cards (and keeping them open), you will increase your capacity by lowering your revolving debt. The second factor, Mix of Credit is improved because the credit score treats certain loans as good and certain loans as bad. Credit card debt is treated less favorably than a personal loan by the credit score. Make sure if you do this, that you lock the credit cards away so you won't use them. Pay everything with cash at least until the personal loan is paid off.
Ignore The Score
Generally, though, you will want to make this decision for reasons other than your credit score. Make sure by getting the personal loan you will improve your overall financial situation. Improving your credit score should be a nice added bonus and not the reason you make this decision. You can determine if your overall financial situation will be improved by answering three questions:
1. Is the interest rate on the personal loan lower than the credit cards?
There is no point in switching from a lower rate credit card to a higher-rate personal loan if you would pay more in interest. While this may seem like the credit card will always be a higher rate, that may not be true. Especially if you were approved for the credit card when you had better credit in the past.
2. Will this enable me to pay off the debt faster?
Another major factor is if this switch will accelerate or slow your ability to pay off the debt. Even if changing to a personal loan is lower interest rate, it won’t help much if it doubles the amount of time it takes you to pay off the debt. The answer to this is as much psychological as it is mathematical. If getting this personal loan will make you feel comfortable with the debt, it may actually cost you more in the long run. This could be true even if the personal loan is a lower interest rate and pays off faster - because you might be psychologically more willing to get into debt further, such as getting a new car.
3. What is the chance that I will rack up more credit card debt in the future (you can't say no chance)?
Consider the last point carefully. While a personal loan may help in the short run, many people who use this strategy end up with similar credit card debt again in a year or two. Effectively, they just double their debt by having both credit card and personal loan debt.
Consider Getting Help
If the answer to the first two question is YES, and the answer to the third is a low chance of using your credit cards again, then the strategy makes sense. Keep in mind, though, that there were reasons why you got into this debt and those habits or mindsets are likely still there. Without external intervention, you
We also offer a financial coaching service which will help you make the right decision and avoid the traps outlined above. For those who are recent graduates or low-income, our nonprofit also offers grants to help pay for financial coaching. And you can also take a Personal Finance class at a local community college.
Post-Debt Life
Once you have the loan paid off, keep pushing forward by shifting the monthly loan payment money to take another step forward in your financial foundation. For example, if the personal loan was a $600 monthly payment, keep making the payment but to another financial goal. The following are some of my favorite places to consider.
Use the money to build up an emergency fund so you can make it through negative financial surprises.
Contribute the money into your 401(k) or an Individual Retirement Account for your retirement.
Put the money into savings for a major goal such as buying a house or purchasing your next car with cash.