A personal loan can affect your credit score in several ways, both positively and negatively. In addition, taking out a personal loan is not inherently harmful to your credit score. However, it may have a short-term effect on your total score, making it harder for you to receive further credit before the new loan is paid back.
In contrast, repaying a personal loan on time should improve your total credit score. If you decide to take one out, properly study and evaluate your alternatives to ensure you qualify for the best deal. Furthermore, while a personal loan has many advantages, the possible drawbacks must also be weighed before signing on the line.
What Is a Personal Loan
A personal loan is a financial arrangement where a borrower provides a fixed sum of money for repayment over time. This includes interest and other costs. Unlike mortgages and vehicle loans, many personal loans are unsecured debts, meaning they are not secured by collateral like a purchased car or home. For this reason, personal loans may have slightly higher interest rates than auto loans or other secured credit. However, their annual percentage rates (APRs) are far less than those of credit cards.
How Does a Personal Loan Affect Your Credit Score
Your credit score is estimated by considering five different factors new credit, credit mix, duration of credit history, payment history, and amounts owing. According to FICO, 10% of your credit score is calculated by any recently opened credit lines or new debt. In addition, the remaining 10% is determined by your credit mix or the total number of open credit lines (including secured credit cards). These precise percentages differ between the three major credit rating agencies.
Therefore, getting a new personal loan can affect your credit score. Furthermore, your remaining debt will grow higher, and need to obtain a new debt. Credit agencies also monitor new financial activities. For instance, your application may be denied if you attempt to apply for a car loan soon after taking out a personal loan because you may already be in too much debt. A single new loan has less of an effect on your credit score than your whole credit history. With a strong debt management history and consistent payments, the impact of a new loan on your credit score is likely minimal.
How Does a Personal Loan Help Your Credit Score
A personal loan can help you by increasing your credit mix and enhancing your payment history. Additionally, it helps to improve your credit utilization ratio if you utilize debt consolidation.
Payment history
The biggest part of your FICO score, or 35 percent is gotten from your payment history. Your credit score will be enhanced if you make consistent early payments on your loan. However, it can take many months for it to be beneficial. Additionally, it will take at least a year to make up for the damage caused by a hard inquiry from the lender when you apply.
Credit mix
Another way personal loans help your credit score is by owning many accounts. The 10% of your FICO score is estimated by your credit mix or the variety of your accounts. For instance, this loan would increase your credit mix and might enhance your credit score if you have two credit cards. Furthermore, the more credit you have, the more evidence there is that you can manage different kinds of debt.
Credit utilization ratio
Consolidating credit card debt with a personal loan might raise your credit utilization ratio (CUR), which accounts for 30% of your FICO score. This is so that you can see how much of your available credit is affected by revolving debt using credit usage measurements.
How Does a Personal Loan Hurt Your Credit Score
Personal loans may be reported to TransUnion, Equifax, and Experian, the three main credit agencies. If it is, the loan could be taken into account when determining your credit ratings. Moreover, this implies that your credit ratings may be impacted or improved by a personal loan.
Here are some instances of how taking out a personal loan might result in a decline in your credit scores:
Missed payments
It’s important to pay bills on schedule and to prevent missing or late payments. Your payment history affects your credit ratings, as the CFPB notes. Additionally, your credit ratings may be higher the better your payment history has been. However, it might lower your credit ratings if you miss or are late with payments.
Hard inquiry
A hard inquiry will occur if you formally apply for a personal loan, even though you can prequalify for one with a soft credit check. Your credit score will be adversely affected, however little, by a single hard credit check. However, applying for many credit accounts in a short period may indicate a higher risk according to FICO.
Outstanding debts
The amount due on your credit also rises when you take out a personal loan. For this reason, your score could slightly decrease. The outstanding debt on your installment loans is one of five components that determine the total amount owing. It also takes into consideration the total amount owing on various credit account kinds.
A preapproval procedure is usually available from most lenders, so you may avoid a harsh hit until you are ready to borrow money. However, having too many at once might be a red flag to potential lenders. If you apply within two weeks, you could also be able to apply with many lenders and have them weighted as a single inquiry.
Final Thoughts
Your credit score will initially take a little knock from a personal loan. However, if you make your payments on time, it will rise again and eventually help you build better credit. To help you choose the ideal loan repayment period, a personal loan calculator might be a great resource.
