On the one hand, you’re constantly advised to stay out of debt. On the other hand, you need to have a good mix of credit, which usually requires taking out a credit card or installment loan.
What’s a debt- and credit-conscious person to do? Is it worth taking out credit building loans to build a better credit mix? Let’s find out.
Pros of loans to build credit mix
Using installment loans as credit building loans
Showing responsible use of credit cards is great when building your credit score.
But if that’s the only credit you’ve got, you may be missing out on an opportunity to show you can handle installment loans, too.
Unlike credit cards which you don’t have to use every month, installment loans require a long-term, consistent commitment. They require you to pay the same amount every month until the loan is paid off.
In other words, an installment loan doesn’t just help you build your credit mix. It also gives you an opportunity to build a years-long history of making on-time payments.
You get the financing you need
If you’re already in the market for a car, looking to start your own business, or need a student loan, an installment loan can help with that.
What’s more, these loans also help you build credit and improve your credit score if you are a responsible borrower.
Cons of credit building loans
Credit mix = 10 percent of your credit score
When FICO figures your credit score, they take five categories into account:
· Payment history = 35 percent
· Amounts owed = 30 percent
· Length of credit history = 15 percent
· New credit = 10 percent
· Credit mix = 10 percent
That said, your credit mix may be weighted more heavily if you don’t have much other credit information for FICO to go on when they’re calculating your credit score.
Installment loans can make your credit worse
Best-case scenario, you make every installment loan payment on time, every time.
Worst-case scenario, you miss a payment here and there. That’s bad news for the category of credit that counts more toward your score than any other – payment history. That’s a whopping 35 percent.
And, just one late payment can knock as much as 100 points off your credit score, if not more.
So if you’re not certain you can swing the monthly payments, think twice before taking out that loan. You could find yourself in over your head later on.
You’re taking on debt
If you’re accustomed to a debt-free lifestyle – or, at the very least, aiming for one – you may not like how it feels having debt hanging over your head.
But the thing to be most concerned about is if you’re already deep in debt. Any boost in your credit mix pales in comparison to the damage more debt could do to your financial well-being.
In fact, your credit score will likely benefit more from paying off debt, not digging a deeper hole.
You’re going to pay interest
Even if you make every payment on time, you’re ultimately going to pay interest on it.
Depending on the loan amount, you could be looking at hundreds, if not thousands, of dollars in interest charged to you over the life of the loan.
Are credit building loans the way to go?
Before you take out installment loans to build credit, make sure you can answer yes to every one of the following questions first.
Do you really need the loan?
If the loan is for something you need, great. But if the loan is for something you want, think twice.
Can you save up and pay with cash instead? Or, at the very least, can you save up enough to lower the amount you borrow? If you answer yes to either of these questions, you should reconsider taking a loan out at the moment.
Can you afford the monthly payments?
Pull out your budget and plug in the payment. Is there anything you can move around to make it work? If the answer is no, then you can’t afford it.
The only exception would be if you can find (and manage) a new source of income as well.
Are you comfortable paying that much interest?
Don’t just look at the monthly interest. Look at the amount you’ll be paying over the life of the loan.
Is what you want today worth paying that much in the long run? If you hesitate before answering, it’s probably not with it.
Are you comfortable taking on new debt?
Essentially, is the promise of a better credit mix worth taking on a new financial obligation? If not, walk away from taking a loan out.
If you answer “no” to one or all of these questions, that’s okay. Keep using your credit cards wisely and wait on credit building loans until the timing is right.
When you practice this kind of financial discipline and forethought, your credit will work out just fine.
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