A hard credit inquiry, increase in personal debt, and your payment records can all have an impact on your credit score, and there’s a potential it could be negative or positive over time. Still, a personal loan is often needed and very beneficial. So, how does it potentially affect your credit score? Read on and find out.
Key Takeaways
- A personal loan is a great way to fund a large purchase or pay off debts with money that is paid back to the lender in installments.
- A personal loan could positively or negatively impact your credit score.
- Knowing if you can afford and make the loan payments on time is essential to maintaining a good credit score.
- Five weighted factors primarily determine your FICO score, and knowing them is crucial.
What Is a Personal Loan?
A personal loan is a loan secured from a bank, credit union, or online lender. The payments and interest rates are typically fixed, so you always know what you will pay. Once your loan funds are deposited into your checking account, just make the monthly payments until your loan is paid off.
A personal loan is not a line of credit, meaning you cannot keep drawing money on it. You receive a fixed amount and pay it off. Additionally, a personal loan could be a secured loan if it is used to purchase something like a car or boat, but it could also be unsecured and solely based on your promise to pay and a signature.
Loan amounts could range tremendously. Your personal loan could be $1,000 or $50,000, depending on your need and credit score. Typically, the loan application is approved or declined, and the funds appear in your bank account within a few days. The lender will report your ongoing payment history to the credit bureaus.
Do Personal Loans Hurt Your Credit?
A personal loan can be very beneficial but could impact your credit score negatively in several ways.
- It’s a hard credit inquiry: The first credit impact comes from the initial loan application. Anytime you apply for a loan or credit card, the lender needs to ensure you are a good bet to repay any debt and does so by requesting your credit report. Pulling your credit report to apply for new credit results in a hard inquiry which could trigger your credit scores to drop, although they are likely to recover over time as you make payments on time.
- Payments matter: Another potential impact on your credit is your payment history, and missing just one loan payment could negatively affect your credit score. Payment history is one of the most significant factors in your score, and a 30, 60, or 90-day late payment will hurt your score and stay on your credit report for seven years. If you are concerned that you might not be able to make your payment on time, it is crucial to communicate with your lender and work out a plan.
- You’re adding to your debts: Lastly, the added debt from a personal loan will show on your credit report as additional debt. Simply having debt doesn’t necessarily hurt your credit score or make you a high-risk borrower, but if you have many high balances, there could be a negative impact. Also, should you apply for new credit, considerable balances could result in a negative debt-to-income ratio and result in being declined for the loan.
How Are FICO Scores Calculated?
A FICO score is the three-digit number lenders use to determine whether or not to loan you money. Additionally, it can impact insurance prices, whether you can rent a home, and the potential to be hired by an employer.
When your credit score is calculated, several main categories are weighted into the score. These categories and their weighted percentages are:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- New credit accounts: 10%
- Types of credit used: 10%
As you can see, on-time payments are critical to maintaining a good score as not to have too much owed to creditors.
Can a Personal Loan Help Your Credit Score?
While a personal loan has the potential to impact your credit score negatively, it could also boost it in several ways and be especially helpful if you have bad credit.
- Improving your credit mix: Having a variety of types of credit could be beneficial to your score. Whereas credit cards are considered revolving credit, a personal loan is an installment loan which means it is steadily paid off over time through monthly payments. Let’s say most of your credit is credit cards; in this case, a personal loan would benefit your credit mix.
- Establishing a payment history: Payment history accounts for 35% of your credit score, and making on-time payments on your loan can help increase your score.
- Lower your credit utilization ratio: Your credit utilization ratio measures the amount of your revolving credit in use. As an installment loan, a personal loan doesn’t count toward that ratio. If a personal loan is used to pay off and consolidate revolving credit, that credit utilization rate will become more favorable, potentially boosting your score.
The most important aspect of taking out a personal loan and improving your credit score is ensuring that the monthly payments are affordable and can be made on time. If you question your ability to make timely payments, avoiding taking out the loan could be in your best interest.
If you can take out a personal loan, pay off revolving debt, and lower your monthly payments, annual percentage rates, or both, a personal loan could tremendously benefit your credit score and wallet.
The Bottom Line: Understand How the System Works
A personal loan could be a valuable tool if used responsibly. It could be used to fund a vacation, make a significant purchase, or pay off other debts. Remember that it can boost or hurt your credit score depending on your personal credit management. Ensure you only take out a loan if you can afford to make the loan payments on time.
Knowing how credit scoring works, taking a loan, and making your payments on time could boost your score, especially if you pay down high-interest credit cards.
