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While it may be tempting to try and improve your credit score by diversifying your credit types, this may not be the answer in all cases. Before trying to improve your credit score by borrowing additional of credit, make sure you really need it.

Understanding your credit score is the first step towards determining if borrowing more money is the right choice for you. There are a number of factors that influence your FICO score. They include:

  • Payment History (35%)
  • Balances Owed (30%)
  • Length of Credit History (15%)
  • Types of Credit Used (10%)
  • New Credit Lines (10%)

Since having different types of credit can help boost your FICO score, you may be considering taking out a loan or financing a new purchase to get the credit lift. As a general rule, never borrow money solely for purposes of building credit. To help you make sure you are doing it for the right reasons, here are some questions to ask yourself.

Do you truly need the loan?

Unless you are absolutely positive that you can repay the loan, refrain from borrowing new credit unless you truly need it. Once you have established that you do need the loan, look for one that carries a 0% interest rate. This can be a great way to maintain a steady cash flow while waiting for a guaranteed source of cash, like an inheritance, to come through.

If this is not the case, it may be wise to avoid taking any new loans or credit. Not only will this end up costing you more money in fees and interest payments, but chances are that it will not give your FICO score the boost you are expecting.

If you truly need the loan and can get a solid interest rate, then go for it. Even better, if you decide to take out an installment loan to purchase a new or used car, you can likely get better rates, a longer term and a higher borrowing limit.

What is the true cost of the loan?

Another factor to consider is the true cost of the loan. If the loan you plan to take out costs less than the debt you currently carry, it may be worth considering. Generally, installment products offer consumers higher limits, lower rates and more time to repay than most credit cards. Average installment loan rates range from 8% to 10% while credit card rates tend to be much higher. In some cases, credit card interest rates can be as high as 24.99%.

If you plan to use an installment loan to consolidate your debt, this may be a great way to improve your FICO score. Not only will this allow you to consolidate all of your debts into a single payment, but you may be able to save on interest as well.

Should I take out a loan if I have cash?

Say you want to make a large purchase and have the cash on hand to do so. Taking out an installment loan and saving your cash may make sense. If you can get a solid rate, say 4% on the loan, you get cheap capital without tying up all of your cash.

If cash flow is a concern and you know for sure that you can make all of your payments, the small amount of interest you will pay may just be worth the risk. For example, if you borrow $10,000 and can secure an APR of 4%, the $400 in annual interest might pale in comparison to the benefits you get from having that emergency stash.

Even better, with a rewards credit card, you can make your stash work for you. If you know of a rewards credit card that pays around 4-5% cash back on purchases, you can easily offset the cost of the loan by using it to pay for things you would have to buy anyway.

In rare instances, if your credit is on the edge of a FICO threshold, it may make sense to go ahead and take out a low-interest loan that you can repay fairly quickly. Since many mortgage lenders make credit decisions around the 640 marker, an installment loan may be just what you need to bump you into that range.

Know Where You Stand

If you are in the process of improving your FICO score, borrowing money you do not need probably is not the answer. When making this decision, remember to consider your existing finances, your credit goals and your ability to repay the loan. After answering these questions, you should have all the information you need to make an informed decision.