Taking out a personal loan can be beneficial. It's versatile, allowing you to use it for several things. These may include paying medical bills, making significant purchases or even consolidating existing debt. Managing it well can work to your advantage — making consistent and timely payments can improve your credit standing.
However, taking out a personal loan also comes with some risks — especially to your credit. Most lenders conduct hard inquiries as part of the application process, which knocks off several points from your credit score.
Knowing how a personal loan affects your credit is crucial if you want to remain financially healthy. After all, your credit score can affect many aspects of your finances, including your interest rates and insurance premiums.
Key Takeaways
A credit score represents your creditworthiness. Credit bureaus use factors such as payments, credit history, new credit, credit utilization and credit mix to calculate it.
Applying for multiple loans or mismanaging existing ones may affect your credit negatively.
It's best to look at several factors before pursuing a personal loan. These include APRs, fees and penalties.
How Your Credit Score Works
Have you ever wondered why lenders keep charging you high-interest rates? Or why do you have a more expensive insurance premium? The answer may lie with your credit score.
In a nutshell, your credit score is a numerical representation of your creditworthiness. A good credit standing sends the message that you can manage debt well. From a lender's point of view, it makes you less of a risk if you're applying for a personal loan. As a result, they may offer more competitive rates.
In contrast, you're more likely to get higher interest rates if your credit score is fair or poor — typically a FICO score of 669 and lower. If you have a personal loan and your lender charges more interest, it may make repayments more challenging.
It's different from a credit history, which looks at your loans and credit card balances and repayment activity. This information, along with your personal details, collection items and public records, is put into a single document — your credit report.
Credit bureaus are organizations that calculate your credit score. They look at multiple factors, such as payment history, length of credit history and credit mix. The three most prominent credit bureaus are TransUnion, Equifax and Experian.
What Makes Up Your Credit Score?
To understand how your credit score works, you need to know the computation behind it. Credit bureaus look at five factors to determine your credit score. These factors each make up a certain percentage of your score. Knowing these can help you develop strategies to boost your credit standing. You'll also have an idea of what activities to avoid.
Credit Score Contributing Factors
- Percentage of ScoreFactor
35%
Payment History
This factor focuses on how well you’ve been able to repay your debts. Making on-time payments of at least the minimum agreed-upon amount increases your credit score because it indicates responsible financial management behavior.30%
Amounts Owed
Your total debt is another factor affecting your credit score. It also looks at your credit utilization, which is how much of your credit line you have used. Your credit standing becomes better with a lower ratio.15%
Length of Credit History
The thing with building credit is that you need to have credit before it happens. If you’ve only established credit recently, you might run into challenges getting a loan. However, remember that it only accounts for 15% of your credit score — managing your payments still affects your credit standing more.10%
Credit Mix
Your credit can come from various sources, such as installment loans, mortgages, retail accounts and credit cards. Having different types of credit increases your credit score. So, if you usually apply for personal loans, using a credit card may lead to a better credit standing.10%
New Credit
Applying for new credit can boost your credit score. It can help you with your credit mix, especially if you go for a different type of credit this time. However, try to space it out — applying for too many within a short span may pull your score down because lenders conduct a hard inquiry as part of their application process.
How Can a Personal Loan Hurt Your Credit?
It’s best to examine several factors to understand how personal loans affect your credit. Although it may help you establish credit, there are also many ways that it could hurt your credit score. However, there are steps you can take to minimize its impact even if you can’t avoid it altogether.
Lenders usually conduct a hard credit inquiry when you apply for a personal loan. Although it only lowers your credit score by less than five points, the effect can become substantial if you pursue multiple applications within a short period.
Because it’s part of most lenders’ processes, there’s no way to avoid it. However, see if your lender has a pre-qualification process. Pre-qualifying won’t affect your credit score and gives you an idea of what loan amount and interest rates you can get.
This way, you can pursue only those personal loan applications where you’re more likely to be approved.
Once your loan application is approved, your primary objective becomes ensuring you repay it. However, it’s best to have a repayment strategy before completing the loan application process.
Remember, missed or delayed payments on your personal loan can hurt your credit score. Those count against your payment history, which is 35% of the calculation. One way of determining whether you can afford your monthly due is by calculating your loan payments in advance.
This way, if it comes out too expensive, you can make some adjustments. These may involve decreasing your loan amount or getting a co-signer to get better rates.
Ensure that you don’t borrow more than what you need. A higher loan amount may give you more cash on hand when the money is released, but it also means your monthly payments will be more expensive.
Debt load refers to the total amount of money you owe across different accounts. These include the balances on your credit cards, mortgages and other installment loans.
When you apply for a new personal loan, one of the areas that lenders review is how much existing debt you have. Borrowers with high debt loads may get higher interest rates because lenders consider them riskier (the amount of debt you already have may make repaying a new one challenging).
You may consider using your personal loan to consolidate existing debt. It can help you lower your debt load and decrease your credit utilization, which boosts your credit score.
Factors to Consider Before Getting a Personal Loan
Given that personal loans can affect your credit score, getting one is something requiring considerable thought. It's still a commitment, regardless of the loan amount. Here are the essential factors to explore before applying.
Your credit standing can affect your personal loan experience considerably. A high credit score tends to get you more competitive rates since lenders view you as creditworthy.
If your credit score is less than ideal, be prepared to pay higher interest. In turn, it makes your monthly payments more expensive. It may mean that repaying your loan becomes more challenging — and remember, missed payments may result in late fees and a lower credit score.
Whether or not you can repay your loan should be your primary concern. A regular income makes repaying your loan more achievable.
However, besides the amount you earn, it's also crucial to understand how much of your income already goes toward repaying existing debts. A lower figure means you have the financial flexibility to take on more debt. However, a higher debt-to-income (DTI) ratio means you have less to spare, so a personal loan may not be the best choice presently.
It's best to know how much money you need. A higher loan amount may prompt lenders to deny your application if you're borrowing a large amount but can't prove you have the means to repay it.
However, you must also ensure that you still will receive the amount you need after the initial fees lenders charge. For example, some origination fees go up to 8%. That can eat up a significant chunk of your proceeds, leaving you in a financial bind.
What makes personal loans attractive to borrowers is their flexibility. While most application processes will ask you to state why you're taking out a loan, most lenders don't impose restrictions on how you can use your proceeds.
However, there are cases when restrictions apply. For example, Upgrade prohibits borrowers from using their proceeds to pay for secondary education or activities considered gambling.
Knowing how much you need to set aside each month to repay your personal loan is crucial. Remember, you're committing to making all the necessary repayments for the entire duration of your loan, whether for the next two, four or five years.
It's best to see how your new monthly payments fit your existing household budget. Remember, missing payments subject you to fees and may pull down your credit score.
Frequently Asked Questions About Credit Scores
Understanding how a personal loan affects your credit is essential to maintaining your financial health. MoneyGeek provides additional information through these commonly asked questions. These may cover areas about this topic not answered by the sections above.
sources
- MyFICO. "Credit Checks: What are Credit Inquiries and How Do They Affect Your FICO Score?." Accessed September 17, 2022.
- FICO. "Average U.S. FICO® Score at 716, Indicating Improvement in Consumer Credit Behaviors Despite Pandemic." Accessed September 17, 2022.
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