A personal loan is a sum of money you borrow from a bank, credit union, or other financial institution. Borrowers use this money for various reasons, such as paying for big purchases like renovations, weddings, vacations, or medical emergencies. Although it is not always a good idea, a personal loan can also be used to consolidate debt, helping you manage your finances.
You must repay personal loans in fixed monthly payments or regular installments with interest. Depending on the size of the loan and the agreed-upon payment structure, a personal loan typically lasts between two and seven years. Some financial institutions also charge extra fees for personal loans. However, these are usually minimal.
Factors That Determine Your Credit Score
Just like other types of credit, taking out a personal loan affects your credit score when lenders make a hard inquiry during the approval process. If approved, your personal loan can continue impacting your credit score until you make the final payment.
Your credit score is a number between 300 and 850. Financial organizations use it to determine your creditworthiness. This model was first developed by the Fair Isaac Corporation (FICO). Therefore, FICO scores are the most frequently used credit scores by lenders.
Higher credit scores typically warrant better interest rates on loans. A bad credit score (300 to 579) can result in a loan application denial because the lender views your application as high-risk. The weight of each may vary depending on the credit rating agency, but five categories determine your FICO score:
- Personal payment history (35%)
- Outstanding money owed (30%)
- Length of credit history (15%)
- New lines of credit (10%)
- Credit mix – various credit lines that you have, such as credit cards, mortgages, and other loans (10%)
How a Personal Loan Improves Your Credit Score
Provided you make timely repayments and use your personal loan responsibly, it can improve your credit score in several ways.
Diversifies your credit mix
The credit mix accounts for 10% of your credit score. It refers to your various credit accounts, including credit cards, mortgages, and other loans like an auto or student loan. Lenders value customers with a diverse credit mix as long as all accounts are well managed. A varied mix demonstrates the ability to repay loans and stay on top of debt.
A personal loan adds a new line to your credit mix, diversifying it further. Maintaining revolving credit from multiple credit accounts can raise your score.
Develops your payment history
Every time you borrow money, you have a chance to build positively on your payment history, increasing your credit score. One of the most critical aspects of your payment history is its length. A long credit history is usually a positive influence on your credit score. However, it is not the only important factor.
Apart from the average age of your credit accounts, your payment history also considers how recently you have used individual accounts. Regular and timely payments improve your credit score.
Reduces your credit utilization ratio
Your credit utilization ratio refers to the amount of revolving credit you use against the total amount of revolving credit you have available. It is calculated by dividing the amount you owe by your credit limit.
For example, if you have $5,000 of credit available on two separate credit cards but your balance between both is just $2,500, your credit utilization ratio is 50%. According to Experian, you should aim to keep your CUR below 30% to avoid negatively affecting your credit score.
While having well-managed revolving credit can be seen as a positive, borrowers must be aware of their credit utilization. Using more than 30% of your available credit can be a red flag for lenders. This indicates that you are at an elevated risk of defaulting on your loan.
By definition, a personal loan is an installment loan, meaning it is repaid over in a set number of scheduled payments. Therefore, it won’t affect your credit utilization ratio. However, using a personal loan to pay off credit card debt or other forms of debt can reduce your credit utilization ratio, improving your credit score.
How a Personal Loan Hurts Your Credit Score
Before you begin the application process, you should be aware of the potentially negative impacts a personal loan can have on your credit score.
Hard credit report inquiry
When you apply for a personal loan, the financial institution must conduct a credit check to determine your creditworthiness. This causes a hard inquiry on your credit report. Hard inquiries negatively impact your credit score by a few points and can stay on your credit report for up to two years.
If you have only a few accounts or a short credit history, hard inquiries may have more of an impact on your credit score.
While a single credit check won’t diminish your score too severely, multiple hard inquiries can harm your credit score. Several inquiries can be consolidated within a week or two, reducing the negative impact. If you’re shopping around for a personal loan to get the best terms, submit your applications within a two-week period to minimize the effect on your score.
Increases your level of debt
Although some level of debt can be beneficial, borrowers must consider their debt-to-income (DTI) ratio. A new personal loan increases the amount of debt you have, potentially harming your credit score.
Significant debt and high credit balances can negatively impact your credit score. Lenders typically won’t approve a loan if your DTI is above 43%.
Loan management is essential to maintaining a healthy credit score. Missing a loan payment can harm your credit score. Payment history holds the most weight in determining your credit score, and a single missed or late payment can have a greater impact on your score than other factors.
A new personal loan creates extra debt. This can make payments more difficult to manage, increasing the risk of default.
How to Protect Your Credit Score With a Personal Loan
There are several ways to protect your credit score when taking out a personal loan.
Only apply for a personal loan when you need it
Applying for a loan you don’t need reduces the average age of your credit accounts and increases overall debt levels. This can negatively impact your credit score and may heighten the risk of default.
Make payments on time
Timely loan payments are essential to maintain a healthy credit score. Consider setting up a direct debit to help you stay on top of payments.
Consider debt consolidation
Debt consolidation is the process of taking out a personal loan to combine your outstanding debts. In some cases, you may be able to secure your personal loan at a lower interest rate, making payments cheaper and easier to manage. Consolidating your debt can lower your credit utilization ratio, improving your credit score.
Learn How to Improve Your Credit Score With Finance is us
Taking out a personal loan shouldn’t adversely affect your credit score as long as you make payments on time. It can even be used to improve your CUR, potentially boosting your credit score over the long-term. Consider your financial position before applying for a personal loan and ensure you have the funds to make payments on time.
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Disclaimer: All content on this site is information of a general nature and does not address the circumstances of any particular entity or individual, nor is the information a substitute for professional financial advice and services.