How does a personal loan affect your credit score?

A personal loan can be either helpful or harmful to your credit score, depending on your current credit score and repayment habits. Although your score will temporarily drop a few points once you apply and your debt level will rise, a personal loan can help your score grow significantly over time. And with a low enough personal loan, you can finance a necessary purchase at low costs.

If you’re unsure how a personal loan will affect your credit, look at the current capacity of your budget to handle another monthly payment. Your score will drop significantly if you are late on your payments or don’t make them at all. That said, a personal loan is packed with benefits, but the potential negative consequences should also be considered before you sign on the dotted line.

How a personal loan can help your credit

A personal loan can benefit you by supplementing your credit mix and improving your payment history. If used to consolidate debt, it can also help with your credit utilization ratio.

Payment history

Your payment history accounts for 35 percent of your FICO score – the biggest chunk. Consistent, on-time payments on your personal loan will increase your score over time. However, it can take a few months for the benefits to add up, and at least a year for the negative consequences of a hard application from the moment you apply to a lender to be offset.

Credit mix

Your credit score benefits from having a variety of open accounts. Credit mix – or the diversity of your accounts – amounts to 10 percent of your FICO score. For example, if you have two credit cards, a personal loan can expand your credit mix and help improve your score. The more types of credit you have, the more you prove that you can handle multiple types of debt.

Credit utilization ratio

Using a personal loan to consolidate credit cards can improve your credit utilization ratio, which makes up 30 percent of your FICO score. That’s because credit utilization measures how much of your available credit is at risk due to revolving debt.

For example, if you have two credit cards with a total credit limit of $10,000, taking out a personal loan and consolidating $5,000 of credit card debt will increase the total amount of credit you have access to. Provided you keep your credit card spending low, you’ll see a drop in your credit utilization ratio – and an increase in your credit score.

How a Personal Loan Can Hurt Your Credit

A personal loan can lower the overall age of your accounts and increase the portion of your credit owed – both of which can lower your score.

Missed payments

In the same way that on-time payments can increase your score, if a lender reports late or missed payments to the credit bureaus, it can lower your credit and remain on your credit report for up to seven years. Unfortunately, there is little you can do if you miss payments. They linger and you will have to focus on making your loan payments regularly to make up for any late or missing payments on your personal loan.

Amount due

When you take out a personal loan, the amount owed on your credit also increases. This may cause you to see a slight drop in your score. The amount owed is made up of five different factors, and how much you have left in installment loans is one part of that. It also takes into account how much is owed in total across different types of credit accounts.

Difficult research

Lenders will run a hard credit check when you apply for a loan. A hard question will temporarily lower your score by as much as 10 points. However, your score should increase again in subsequent months after you start making payments.

Too much at once can be a bad sign for potential lenders, but fortunately most offer a pre-approval process so you can avoid a hard hit until you’re ready to borrow. You may also be able to apply to multiple lenders and have them weighed as a single application if you apply within a two-week period.

How credit score affects your overall financial health

Your credit score is a measure of how well you handle your financial accounts. This in turn helps lenders decide whether they can take the risk of lending you money. Therefore, the higher the better.

Additionally, insurers, employers and landlords can use your credit profile as a test of reliability in some states. Your credit score may not be immediately visible in all cases, but what affects your credit score will be.

In its simplest form, a strong credit background will help you qualify for lower interest rates and more competitive terms. It can also serve as a positive indicator outside of finances. Credit checks and the weight of your credit score are unavoidable truths in today’s economy, so it’s wise to work to continually improve them.

When should you consider taking out a personal loan?

Personal loans are an important tool for financing major expenses such as home renovation and debt consolidation. Even though you may see a temporary drop in your score, there are times when a personal loan may be the right choice to improve your credit.

It should be noted, however, that a personal loan is not necessary to build a healthy credit score. These are simply ways it can positively impact your credit.

• You don’t have many outstanding bills. If you’re just starting out, you may have no credit history. A well-managed personal loan is a good way to start building your history, as it has a term of two to five years – and then stays on your credit report for up to seven years once you’ve finished paying it off .
• You only have revolving debts. Credit mix is ​​a small part of your score, but it still matters. If you only have credit cards, a personal loan can add diversity to your credit mix, showing lenders that you are financially responsible enough to handle a variety of debts.
• You want to save money. A personal loan can be used, among other things, to consolidate debts to save money. In some cases, a personal loan can help you lower your average interest rate on various accounts and help you avoid the fees charged by credit cards.

The bottom line

Any new debt can be risky for your finances, so consider alternatives to personal loans before signing up. Make sure you can make your payments each month with a personal loan calculator, and know that a small dip can easily be overcome by being responsible with your debts.