How much will a secured loan improve my credit score? The answer depends on multiple factors acting independently or together, depending on your debt circumstances. Usually, getting a secured loan is a strategy for paying for something over time that we need or want now. However, getting a secured loan to build credit can also be an effective financial tool.
Highlights:
- Adding a secured loan to your mix of credit types can positively impact your credit score.
- As with any credit type, failure to make on-time payments will negatively affect your score.
- Several types of secured loans exist.
What is a Secured Loan?
A secured loan is simply a loan from a bank or other lender that involves collateral. Many types of secured loans are available, mostly named by the type of collateral involved. Collateral is an item or asset that you have in your possession, which will be forfeited if you fail to pay the loan according to its terms. The type of collateral may be directly associated with the loan, such as a car loan, or be independent of the loan, such as a savings-secured loan.
An Expert’s View
The collateral alone differentiates a secured loan from an unsecured loan. Annie Cole, EdD, the Founder and a Money Coach at Money Essentials for Women, sums up the relationship between secured loans and your credit score this way.
“A secured loan, like a mortgage or car loan, requires you to put your collateral (goods, home, car) on the line in the case of a loan default. These types of loans can have a big impact on your credit score, positively or negatively, depending on how you manage them.
Your credit score is generally calculated using either the FICO formula or the VantageScore formula and is calculated based on your payment history, length of credit, types of credit, balances, and more.
So, if you set up a new secured loan, this can have a positive impact on your credit score because you’re 1) Adding a mix of credit types to your history, 2) Making on-time payments over time, and 3) Paying down a significant balance. However, if mismanaged, it can negatively impact your credit score. For example, if you open too many new loans at once or don’t make payments on time, it is a sign of risk and will cause your score to drop.
When you apply for a loan, the lender will check your credit, which can temporarily cause your score to drop by a few points, but this should bounce back once you start making payments on the balance.”
Types of Secured Loans
What a secured loan is called is often closely related to the type of collateral that backs up its terms. A car loan, for instance, is a secured loan in which the automobile acts as an incentive for the borrower to continue making payments while providing security for the lender. In any secured loan, if a borrower fails to pay on time or otherwise violates the loan terms, the lender can seize, repossess, or place a lien on the property or collateral tied to the loan. Common types of secured loans include the following:
- Automobile or other vehicle
- Boat, RV, ATV
- Mortgage
- Auto title
- Life insurance
- Pawn
- Savings or CD
- Reverse mortgage
- Home equity loan or line of credit
How Is My Credit Score Determined?
It’s essential to get a feel for how the three major credit bureaus, including Experian, Equifax, and Transunion, determine your credit score to understand how a secured loan can improve your credit score.
Called a FICO score, five primary factors are evaluated monthly, resulting in a total number between 300 and 850, which generally reflects the amount of risk you pose to lenders or your creditworthiness. VantageScore is another model often used by lenders, which is different from FICO but uses similar metrics to award your credit score. The higher the number, the better your credit score is said to be.
All of the factors are determined by evaluating your credit report, which is a statement that includes details about your relationship with credit and debt. A credit report is closely related to your credit score, but not the same thing.
Credit Score Factors
The five components that make up your credit score are given a percentage, which represents the amount of weight each one contributes to the total.
- Payment history accounts for 35% of your score and reflects how consistently you make loan payments, including revolving credit payments, on time. Bankrupcies on your credit report will show up in this category and will lower your factor rating for this component.
- Amount you owe accounts for 30% of your score and measures how much you owe against how much credit you have available. The higher the ratio, the lower your score for this factor.
- Credit history length accounts for 15% of your score and averages the amount of time your credit accounts have existed.
- New credit frequency accounts for 10% of your score and measures the time between recent applications for new credit. The higher the frequency, the lower the score. This is where your ‘hard inquiries’ will appear in your credit report.
- Mix of credit types accounts for 10% of your score and reflects the various types of credit you have in your credit report. A good score in this category reflects a mix of secured and unsecured debt, including revolving and installment credit accounts.
An item that won’t appear on your credit score but will still affect a lender’s decision about whether to award you a loan is your debt-to-income ratio (DTI). Your DTI is a metric lenders use to help determine whether you have enough money available to make your payments on time. It’s derived by dividing your monthly debt payments total by your monthly income before taxes are taken out.
Your DTI comes into play in determining a lender’s risk. Your new credit card limit, secured or unsecured loan amount, and the interest rate (APR) you’ll pay for borrowing are all closely tied to your DTI. A good DTI in the eyes of a lender is below 35%, while significantly more than 40% looks risky to lenders.
How Can a Secured Loan Improve My Credit Score
All credit and loans affect your credit score whether you want them to or not. How and by how much a secured loan can improve your credit score is highly variable based on details in your credit report.
If you’re looking to build credit or rebuild a poor credit score, adding a secure loan can have a significant positive impact, provided you make all of your payments on time and in the full amount due for each month.
In fact, because a secured loan provides the lender with some protection, a secured loan is typically easier to qualify for than an unsecured loan or revolving credit.
Additionally, if you have no or few secured loans on your credit report, adding one to the mix can improve your score related to the types of credit you have, which, although not the most significant factor, does play into your total credit score.
How much will a secured loan improve my credit score?
I’d love to be able to tell you precisely how much a secured loan will improve your credit score. The reality, however, is that it depends on several factors we’re discussing in this article, most of which are in your control. In truth, the amount of credit score improvement you can expect to see has little to do with the loan and loan type itself and more to do with its potential for improving your credit mix tally.
When you apply for a secured loan, your credit score will first take a slight and temporary dip as the new credit inquiry takes its toll on your credit report. Provided you make on-time payments, you should see your score begin to improve after several months. Any hard pulls or inquiries made to secure the loan will fall off of your report after 24 months. As the loan ages, your credit history length will increase, which also works to improve your score.
Secured Loan Pros and Cons
Of course, taking on a secured loan doesn’t automatically and immediately improve your credit score. If you’re thinking of obtaining a secured loan, consider these factors.
Pros
- Works in several ways to improve your credit score
- Often features lower interest rates than other loan types
- Has a built-in incentive to continue making payments
Cons
- Requires collateral, which you risk losing by not making on-time payments
- Your credit score will temporarily dip when you apply for a secured loan
- While considered ‘good debt,’ a secured loan still increases your DTI ratio
How to Save Money When Getting a Secured Loan
Getting a secured loan is usually something consumers turn to when purchasing a large item, such as a home or car. However, other collateral can include things like a savings account balance, home equity amount, or other assets or possessions. Whatever the case, there are several ways to help control costs when obtaining a secured loan.
- Consider purchasing a lower-cost item, such as a used versus a new car. The monthly payments will generally be lower and will have a smaller effect on your DTI, which can leave you open to future opportunities.
- Commit to putting down a significant down payment on the loan. Doing so can lower the interest rate on the loan and even help make the loan easier to qualify for.
- Shop around for a low APR. However, it’s important to be careful to avoid multiple hard inquiries. Look for lenders willing to perform a soft inquiry on your credit report to help determine your likelihood of approval for the loan before formally applying for it.
- Making payments that are larger than the minimum amount due each month will reduce the overall amount of interest you’ll pay over the life of the loan. Make sure your lender doesn’t penalize you for making early payments, though. (This is uncommon, but it does exist.)
Other Ways to Improve Your Credit Score
Obtaining and properly maintaining a secured loan is just one way to help improve your credit score. The most effective ways, such as making payments on time and reducing your debt load, take time but are well worth the effort.
Make On-Time Payments
Paying your monthly payment in full and on time is the most effective way to improve your credit score. Doing so directly impacts your payment history evaluation results, which account for 35% of your credit score.
Reduce Credit Utilization
Reducing the amount you owe as related to your credit limit amounts will result in a higher credit score without having to take on any additional debt. Reducing your credit utilization improves the amount-you-owe ratio, which makes up 30% of your credit score.
Diversify Your Credit
Diversifying the types of credit that appear on your report can improve your overall score. Personal loans, unsecured credit card cards, secured credit cards, or student loans can yield similar credit-improving results as secured loans if you already have secured debt on your credit report.
Monitor Your Credit Report and Score
While monitoring your credit score won’t directly improve your credit score, doing so can protect you from potential threats to your credit well-being. The best credit monitoring and identity theft companies can help you maintain the credit score you’ve already achieved.
Credit-Builder Loans
A credit-builder loan is a unique type of secured loan designed for those who wish to improve their credit score. Instead of hard collateral, the borrower puts money into a savings account that acts as collateral for the lender. The lender matches the amount in the account with a loan, which the borrower can then make payments against to help build credit. When all payments are complete, the borrower gets to keep and access the dollar amount in the savings account.
Use the Help a Co-Borrower
If you have bad credit, getting any loan can be challenging, and you’re likely to experience high interest rates and other associated costs, like origination fees. One way to circumvent these situations is to use a cosigner on a loan or credit account, secured or otherwise. Another version of this strategy would be to sign on as an authorized user of your co-borrower’s established credit account.
While these are effective ways to build credit, there are risks to your cosigner that require consideration before entering into an arrangement. For instance, if you default on your part of the deal, your cosigner is on the hook for the balance, and it can and will affect their credit score as well.
Is Taking Out a Secured Loan to Improve My Credit Score Worth It?
While taking out a secured loan can improve your credit score over time, there are numerous factors to consider before doing so. Obtaining a secured loan to improve credit comes with both risks and rewards. However, there are several ways to improve your credit score, many of which don’t involve any additions to your debt load. That said, if you need to make a large purchase and have few or no other secured loans open on your credit report, taking one on can be worth it and can help improve your score over time.
Also see: Can Taking Out a Personal Loan Improve My Credit Score?
