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The 5 Ways a Personal Loan Can Affect Your Credit Score
Maintaining your credit score is a pretty important part of modern day life. While it is possible to live a rich and full life without any credit score whatsoever, it’s not the easiest financial situation. With bad credit, it is difficult to get good terms on any of your bad credit loan options, which all have higher interest rates. If you have a good credit score, you’ll be able to access the best personal loans at loan amounts you need with lower interest rates.
Unsecured personal loans, secured loans, and lines of credit can all lead to excellent credit or poor credit, depending how they’re used. For example, borrowers who are careful to avoid unaffordable loans and make consistent loan payments on time could see their credit scores improve. In this post, we’ll give you a detailed overview of how a personal loan can both harm and help your credit score
How your credit score works
Your credit score represents your creditworthiness. It’s based on information from your credit reports, which tracks your credit history roughly over the past seven years. Credit reports are compiled by the three major credit bureaus: TransUnion, Experian, and Equifax.
Credit reports contain a whole range of information, including:
- The amount of credit you’ve used
- The amount of credit available to you
- Your payment history
- The dates each of your accounts were opened
- The types of credit you have
- Your bankruptcies and other public records
- Hard credit inquiries
All that information is then fed through a credit scoring system to create your credit score. The most common type of score is your FICO score, which is scored on a scale from 300 to 850. The higher your score, the better. Any score above 720 is generally considered good credit, while any score below 630 is considered poor credit.
Your credit score is calculated from five factors, listed below in descending order of importance:
- Payment history (35%)
- Amounts owed (30%)
- Length of your credit history (15%)
- Credit mix (10%)
- Recent credit inquiries (10%)
1. How a personal loan affects your payment history.
A personal installment loan is a type of loan broken up into a series of smaller regular payments. By making biweekly or monthly payments on time, you should see an increase in your credit score. On the other hand, a missed or late payment can hurt it.
On-time repayments can only help your credit if the lender reports your payments to the credit bureaus, so consider loan options that provide this benefit. Most payday loans lenders will report late payments, adding insult to the injury of late fees.
Payment history is the single most important part of your credit score. One late payment can dramatically lower your score. But it takes months (or sometimes years) of on-time payments to establish a sterling payment history to keep your score afloat.
Having no payment history can cause problems when it comes to the credit application process. You need to prove you can use credit to get credit, which may seem like a contradiction.
One solution is to find a co-signer with established credit to help you take out a loan. You could also look into alternative financial institutions, like credit unions.
2. How a personal loan affects your amounts owed.
When you take out a personal loan, you are adding debt to your total amounts owed. This will probably lower your credit score in the short-term. A higher debt load is associated with a higher risk of taking on more than you can handle, which means lenders may see you as a higher risk.
This is one area where credit cards have a leg-up on personal loans. With a credit card, you can help maintain your credit score by never using more than 30% of your card’s credit limit. As long as you pay off your entire credit card balance before the due date each month, you won’t have to make any interest payments.
Most credit cards have a grace period, which is a period of time during which interest does not start to accumulate. Using your card to make purchases you would need to make anyway and paying off the bill in full each month can be an effective way to raise your credit score over time.
3 & 4. How a personal loan affects your length of history and credit mix.
While these factors are less important than your payment history and your amounts owed, they can still help or hurt your credit score. Your credit mix will depend on the types of credit you’ve taken out. You should consider if a personal loan makes your mix of loans and cards more or less diverse. For instance, if you have two credit cards and a home equity loan (all of which you are using responsibly), then taking out a personal loan could help your score because it means you’re using a new kind of credit.
Whereas, if you take a loan offer from an online lender in addition to two other personal loans you’ve already taken out, your score may get dinged. The more diverse your credit mix, the more it can help your credit.
In regards to the length of your credit history, most traditional installment loans come with a multi-year repayment period. The longer you’ve been paying off the loan, the older the average age of your credit accounts. Older credit accounts help your score because they show that you’ve been able to maintain long-term relationships with your lenders.
There is, however, a weird downside here. Some borrowers have found that when they finally pay off a long-term loan, like a student loan, their score may actually take a small hit. Closing out an account will lower the average age of your open accounts, which can hurt your overall score. This is also why you shouldn’t always close old credit cards. The age of those accounts (plus the higher overall credit limit) can help your score.
5. A new personal loan means new credit inquiries.
When you apply for a traditional personal loan, the lender will likely run a credit check. While a soft credit check will not affect your credit score, a hard credit check will. A hard credit check involves pulling a full copy of your credit report so the lender can view your credit history. A hard credit check is standard procedure for many personal loans, auto loans, and mortgages.
Recent hard credit inquiries will ding your score. Not for too much, and not for too long, but you should still be careful about how many loan applications you fill out in a short period. With home and auto loans, multiple inquiries can be bundled together on your score, but this generally doesn’t happen with standard personal loans.
Above all else, borrow responsibly.
The most important part about taking out a personal loan is to use it responsibly. Don’t take out more money than you afford, and make your payments on time. If you do all that, your personal loan may end up being a net positive for your credit score.