Use unsecured loans right and you’ll boost your score, miss a payment and you’ll destroy it
Think unsecured loans can’t affect your credit score or that they’re different than other loans? Think again. I’ve seen way too many people destroy their credit with unsecured loans because of common misconceptions.
It’s not that unsecured loans are bad. They can actually be a good source of quick cash and a way to increase your credit score when used correctly. It’s the way people think about this type of debt that gets them in trouble. The fact that you don’t have to worry about losing your house or car if the loan isn’t paid off gives people a false sense of security with unsecured loans.
What they don’t understand is that missing a payment or defaulting on any type of debt can come back to bite you when you need another loan.
Types of Unsecured Loans
There’s three main forms of unsecured loans with which most people are familiar. Credit cards, student loans and personal loans are all forms of credit where you don’t have to put up collateral for the money.
Personal loans and student loans have a fixed payment and a set payoff date unless you refinance the loan or change the terms. Making regular payments on these loans will help improve your credit score through a strong payment history, a factor that accounts for 35% of your credit score.
Credit cards are slightly different because they are considered revolving credit, a loan that you can continue to borrow on and pay off a little each month. Making regular payments on your credit card debt can help improve your credit score but doesn’t help as much as regular payments on other types of unsecured loans. It’s because the credit report agencies use your type of debt, revolving or non-revolving, for up to 10% of your credit score. Lots of revolving debt doesn’t look as good because you never have a payoff date and your payments can change each month.
For credit cards, it’s important to get a card that can offer a low rate past the introductory period. Most cards will give you a great deal for a year but then your rate jumps and you’re left paying a pile of interest. Being able to earn rewards points is a bonus but doesn’t make up for a high interest rate. I’ve used the USAA.com Visa card since I got out of the military. It’s one of the best rates I’ve found on any credit card and it’s open to just about anyone, even people that are not in the armed forces.
While student loans can only be used for one purpose, personal loans are pretty much up to you how you use the money. The majority of personal loans are used to pay off high-interest rate credit card debt but people are also using the loans for home improvement, medical expenses and even vacation plans. Personal loan rates can get expensive if you have bad credit so you need to shop around to get the best deal. I’ve used Avant Credit for its no origination fee and the ability to refinance the loan for a better rate later.
Default rates for student loans have jumped to over 10% and many are wondering if the $1 trillion+ student loan market is the next big financial crisis waiting to happen. Defaults on personal loans through Lending Club are around 6% while just under 3% of credit card debt isn’t paid.
The problem with unsecured loans is that people don’t prioritize them along with home loans or car loans. Unsecured loans get reported to the credit agencies and missing a payment affects your credit score just like any loan. Your credit card debt and personal loans might get wiped out in a bankruptcy but you generally will still have to repay your student loans.
Don’t miss these top 10 personal loan sites for other options.
Which is Better, Secured or Unsecured Loans?
Rates are usually lower for loans you have to secure with some type of collateral like a home mortgage or an auto loan. The problem with secured loans is that you need collateral to put down and they aren’t much help if you need money quickly. You might be able to refinance your home but your car loan isn’t going to give you any money beyond just buying the car.
If you do have equity in your home and need a loan, you should try refinancing through Lending Tree before considering personal loans or other unsecured credit. It will take a little longer because you’ll need an appraisal but the rate on your refinance will be much lower than an unsecured loan.
It can be fairly easy to get either type of loan though your rate will be higher for an unsecured loan depending on your credit score. Most loans will help you increase your credit score if you make regular payments. If you get auto financing through the place where you buy your car, make sure they report the loan on your credit report so the payments help build credit. Payday loans and cash advances are about the only loans that won’t help you build credit and rates are so high that you’re better off avoiding these if you can.
Missing a payment on your loan can cause your credit score to plunge. FICO reports that missing a mortgage payment can decrease your score from 70 to 100 points while a bankruptcy can lower your credit score by 230 points or more. It will take between nine months to three years to get your credit score back after just a missed payment and up to ten years to repair your score after a bankruptcy. It’s best to avoid these problems if you can but I’ve put together the ultimate guide of 21 steps to fix bad credit on my personal finance blog.
Unsecured loans go on your credit report and can affect your credit score just as much as any other type of loan. While it’s better to default on an unsecured loan compared to your mortgage or car loan, you’ll still destroy your credit score and might not be able to get the money you need when you need it. Use debt responsibly, only taking as much as you need and can afford, and you’ll improve your credit score and will get lower rates on your loans.