Personal loans can help or hurt your credit score. It depends on how they’re managed. Ideally, you want to make loan payments as agreed and on time to preserve your positive credit rating and possibly improve it. Otherwise, you could do more harm than good by taking out a personal loan.
What are Personal Loans?
A personal loan is a type of installment loan that can be used for an assortment of reasons. This form of credit is generally available from traditional banks, credit unions, online lenders and other financial institutions.
Most come with a set loan term – between one and five years- and a fixed interest rate, giving you equal monthly installments. The financing terms you receive are usually based on your credit rating and debt-to-income ratio.
Common Types of Personal Loans
Personal loans come in many forms. Here’s a closer look at the most common types of personal loans to choose from:
- Unsecured personal loans: Most personal loans fall into this category. As the name suggests, unsecured personal loans do not require collateral.
- Secured personal loans: Collateral is required to secure a personal loan. You could get a lower interest rate, but your asset is at risk for seizure if you default on the loan payments.
- Joint loans: These are personal loans with joint borrowers where both parties assume equal responsibility for the outstanding balance. Both borrowers also have access to the loan proceeds.
- Co-signed loans: If you can’t get approved for a personal loan on your own, a co-signer could help your case. They agree to repay the loan if you can’t, despite not having access to the loan proceeds.
- Debt consolidation loans: These loans are used to combine multiple unsecured debts (i.e., credit cards, other higher-interest loans, medical debt) into a single loan product, preferably with a lower interest. You’ll get a single and hopefully more affordable monthly loan payment, making managing the balances easier.
- Home improvement loans: You’ll use these loans to make home upgrades or renovations.
- Personal lines of credit: Although they are categorized as personal loans, personal lines of credit work like credit cards. You can pull from a pool of cash as needed, up to the limit, and re-use the funds as you make payments. Unlike traditional personal loans, interest is only assessed on the funds you borrow.
Do Personal Loans Affect Credit Scores?
Personal loans can hurt or help your credit score. Before diving into the reasons why, it’s vital to understand how credit scores are calculated.
Factors That Affect Your Credit Score
FICO scores – used by 90 percent of lenders and creditors – are divided into five components:
- Payment History (35 percent of your FICO score)
- Total Amount Owed (30 percent of your FICO score)
- Length of Credit History (15 percent of your FICO score)
- Credit Mix (10 percent of your FICO score)
- Credit Inquiries (10 percent of your FICO score)
These scores range from 300 to 850. A higher credit score indicates you’re a creditworthy borrower and will likely qualify for competitive personal loan offers. However, consumers with lower credit scores have fewer options or often settle for subprime personal loans with exorbitant fees and interest rates.
How Personal Loans Can Hurt Your Credit
Here’s how personal loans can damage your credit.
Delay in Repayment
The credit-scoring model does not take payment history lightly. But, that said, a single late payment can severely damage your credit score. Fortunately, lenders don’t report late payments until accounts are at least 30 days past due. So, this gives you an ample amount of time to bring the account current or to connect with the lender to work out a payment arrangement.
Increases Your Total Debt
Your debt load increases when you take out a personal loan. But there’s another downside to be mindful of. If you use a personal loan to consolidate debt and continue using credit cards, two things will happen. You’ll have more debt than you started with, and your debt utilization ratio will increase. Both outcomes could tarnish your credit health.
Having Too Many Credit Inquiries
Each application for credit results in a hard inquiry that could temporarily dip your credit score. Too many hard inquiries in a short period could mean bad news for your credit score and make you look riskier in the eyes of potential creditors and lenders. (Note: The FICO credit-scoring model allows rate shopping to reduce the negative impact of multiple credit inquiries in a short period if you’re looking around for the best rate and terms).
Additional Fees
These added costs wouldn’t impact your credit but are worth mentioning. Depending on how much they are, you could find yourself with unaffordable monthly loan payments that stretch your budget thin. You also risk falling behind on the payments and dinging your credit score if the lender reports the delinquency to the credit bureaus.
How Personal Loans Can Help Your Credit
Personal loans can also help your credit in many ways.
On-time Payments
As mentioned above, payment history is the most significant component of the credit-scoring equation. So, on-time payments can help improve your payment history and boost your overall credit rating.
Builds a Positive Credit History
A personal loan can also help build a positive credit history if you make timely payments each month. It’s equally important to pay the entire amount owed for the month and not just a portion to get full credit for the loan payment and avoid adverse credit reporting.
Adds to Credit Mix
You can also improve your credit mix by taking out a personal loan. Unfortunately, it doesn’t hold as much weight as the other credit score components. Still, the impact can be positive if a bulk of your credit accounts are revolving (or credit card accounts).
Reduces Your Credit Utilization Ratio
If you use a personal loan to consolidate credit card debt, you can significantly improve your credit utilization rate. This figure is calculated by dividing your total outstanding revolving debt balances by the total credit limit across the board. In addition, consolidating automatically reduces your credit utilization ratio, which could also help improve your credit score.
When Should You Take Out a Personal Loan?
A personal loan could be sensible if you have a viable use for the funds. However, it’s equally important to run the numbers before applying to confirm you can comfortably afford the loan payments. Otherwise, you risk borrowing more than you can handle and damaging your credit score.
Find the Best Personal Loans While Improving Your Credit
Instead of spending hours scouring the web in search of loan options, use Experian CreditMatch to lend a helping hand. It’s a free tool that helps you find the best personal loans, based on your FICO Score, to meet your needs. The tool is easy to use and doesn’t impact your credit score.
When you sign up for Experian CreditMatch, you’ll also get access to the following:
- Monthly Experian credit report and FICO score updates
- Experian credit report monitoring and FICO score tracking
- Real-time FICO score alerts
- Experian Boost to help increase your FICO score
Head over to Experian.com to sign up and access all the other free perks.
