How Do Personal Loans Affect my Credit Score?
Personal loans can seriously impact your credit score. However, it’s not accurate to say that they will always help or hurt.
The impact that they have will depend on how effectively you manage your debt.
The information below can help you make a more informed decision on whether to take out a personal loan to improve your credit score.
You’ll learn what it means to take on personal loans, how your credit score can benefit, and what actions may cause your score to fall.
What is a personal loan?
A personal loan is a type of debt that offers you quick access to funds and short to medium-term repayment options.
They are typically flexible and can be used to cover different expenses including:
- Major events such as weddings
- Medical or veterinary costs
- Home repairs
- Home improvement
- Debt consolidation
- Financing an investment
How do personal loans work?
Personal loans are typically provided as a lump-sum payment and repaid in installments. You may be asked how you intend to use them as part of the application process.
Even if you are approved for a loan for a particular purpose (for example, home improvement), you may not be contractually restricted from using the funds for other purposes.
Most personal loans are often unsecured (meaning that you do not need to provide collateral). They can be attractive options because they come with lower interest rates than credit cards or short-term, high-interest loans like payday loans.
"It makes no sense to pay higher rates than you have to..."
Most personal loans are often unsecured (meaning that you do not need to provide collateral). They can be attractive options because they come with lower interest rates than credit cards or short-term, high-interest loans like payday loans.
How do credit scores work?
Credit scores are a measurement of your financial health. You have several different credit scores that various credit agencies compile. FICO and VantageScore are the models that are the most widely used.
FICO develops scores by considering the following factors:
- Payment history: This factor is based on how you’ve paid into your accounts over your credit history and whether the payments were on time. It accounts for as much as 35% of the total of your FICO score.
- The amount owed: This factor is based on the total amount of debt that you hold. It’s a significant factor that may account for as much as 30% of your FICO score.
- Length of credit history: This factor is based on the amount of time you’ve held accounts, such as debit or savings accounts. It may account for as much as 15% of your FICO score.
- New credit: This factor is based on how many accounts you opened in the last year. It may account for as much as 10% of your FICO score.
- Credit Mix: This factor is based on the types of credit accounts that you owe. Installment accounts (like personal loans) are the most weighted. This factor accounts for the last 10% of your credit score.
"We are often surrounded by the very assets that can help pull us out of the fire..."
Does a personal loan show up on your credit report?
Yes. Personal loans will show up on your credit report as soon as they have been updated. Each loan will affect several of the factors listed above. Each new loan counts as new credit and increases the amount owed.
Does paying off a loan early hurt your credit score?
Paying a personal loan off early should not hurt your credit score.
Paying off a loan early will decrease the total debt you hold. If you have a high amount of debt, lowering that number can increase your credit score. If you don’t carry much overall debt, paying off a loan early may simply not affect at all.
However, the total number of payments you have made in your credit history can be a factor in your score. In some cases, making more payments rather than fewer can improve your score.
"Personal lending is just a tool, like fire, it can save you or burn you depending on how it's used..."
Ultimately your goal is to become debt-free, so if the money you borrow is paid direct to you, don't be tempted to spend it before you use it to pay off your cards.
What are the positive impacts of personal loans?
Personal loans can positively impact your credit score in the following ways:
- They help you develop a better credit mix Installment loans have the greatest effect on the credit mix factor of your credit score. These types of loans are more likely to increase your score than credit cards, charge accounts, or other types of debt.
- They help you build a longer payment history Taking out a loan is an effective way to develop a payment history if you don’t have one yet. As long as you hold the account, you will continue to establish a payment history.
- They can help you Reduce your credit utilization ratio One factor that can lower your score is utilizing a high percentage of your available credit. For example, if you are close to your credit card limits, you are seen as more at-risk. You can use personal loans to pay off credit cards and lower your utilization.
What are the negative Impacts of personal loans?
Personal loans can lower your credit score in the following ways:
- Missing a personal loan payment can hurt your credit Taking on debt is always a risk. If you take on a personal loan that you can’t afford, you are at risk of missing payments. Missing payments will cause marks against your credit history.
Your credit history is the most heavily-weighted factor in your credit score. A missed payment will lower your score, and the mark will remain on your credit for a long time.
- Applying for a personal loan can trigger a hard credit check
When you apply for a personal loan, your loan servicer may perform a credit check. This is called a hard credit check. Unlike the credit checks that you perform for yourself on websites and apps, this one may count against your score.
- A loan will add debt The amount you owe will be considered part of your total debt. If this amount is high relative to your income, it can negatively impact your credit score. If you maintain high amounts of debt over time, your score may continue to drop.
Summary
Personal loans play a significant role in your credit score. When you manage debt well, personal loans can significantly improve your score over time. They help you establish a history of financial responsibility and prove that you can handle larger debts like mortgages.
However, when you manage debt badly, personal loans can do severe damage to your credit score. If you maintain too much debt (or fail to make payments on your loans), your score will drop over time. It may take years for you to correct it.
Consider your options carefully before you take on new personal loans.
"Imagine how fast could you pay off your balances if your monthly payments were cut in half overnight..."
