What is The Impact of Personal Loans on Your Credit Score?

ElitePersonalFinance
Last Update: February 4, 2021 Credit Report Loans

From time to time, everyone needs a financial infusion. Getting a personal loan is a good way to get quick cash for various purposes. An unsecured personal loan can help you accomplish some of your financial goals without placing collateral or sharing a specific purpose with your lender.

But then you think of debt, you probably get shivers down your spine. However, it doesn’t have to be like that. If you use your credit cards and personal loans wisely, you can improve your credit score. Even though this sounds illogical, it is true. If you manage to make all your payments on time and in full, your credit score can easily increase.

However, if you fail to meet your financial obligations, you can seriously harm your credit score. This is why you need to consider the impact of personal loans on your credit score in both cases before you even start searching for a loan.

This article will help you find out all details about the impact of personal loans on your credit score and how to get the most out of your loan.

What Make Your Credit Score?

According to FICO, the company that provides people with the most popular formula for calculating their credit score, there are five different credit score factors.

These are the five credit score factors:

  • Payment history – 35%

Do you make all your payments on time? If you have made any late payments, this can negatively impact your credit score. In case you miss any payments, they are typically reported to credit reporting agencies if you are late 30 days or more.

  • Amounts you own – 30%

Do you have a lot of debt? Of course, the less debt you have, the better off you are. It is best to keep your statement balance below 20% of the credit limit.

  • Length of your credit history – 15%

The longer you have had credit, the better. Also, if you want to get the best credit score, you need to have activities each month.

  • Credit mix – 10%

Credit mix refers to the types of different accounts making up your credit report. These include credit cards, student loans, automobile loans, and mortgages.

  • New credit – 10%

This pertains to all credit accounts which performed a hard inquiry on your credit report in the past 24 months.

With a personal loan, the main factors that affect your score are your credit history length and new credit. When applying for this type of loan, a hard inquiry will be performed on your credit, which will appear on your credit report and affect your credit score.

But the impact doesn’t have to be huge. According to FICO, most people’s score will be reduced by only five points. However, when you shop around for loans at online lenders, there shouldn’t be any hard inquiries, so take your time to research and compare as many loans as possible.

Still, if you are making a lot of inquiries within a short period of time, this can harm your credit. Also, if you have many new credit accounts, this can significantly reduce your score.

What Should You Know Before Applying for a Loan?

People tend to make mistakes when applying for personal loans. To prevent this from happening to you, there are some things you need to know.

  • Know your credit score

Ensure you check your credit score before you start searching for a personal loan. You can do this very easily. Get a free copy of your credit score at one of the credit bureaus. If you think you can’t get an affordable loan with your score, you are probably right. In that case, the first thing you should do is improve your credit score.

  • Do your research

Before you choose the loan that you think will be the best fit for your needs, make sure you take your time to research the market. The lending market is becoming more flexible, and you can definitely find a loan with favorable terms.

  • Be careful

Always take some time before accepting a loan. Pay attention to any hidden fees, loan terms, APR, and so on. In addition, stay away from predatory loans. They do not perform a hard inquiry on your credit score, but their terms are far from favorable, and they can easily get you into a debt cycle.

Negative Correlation Between Personal Loans and Credit Score

People usually loans with negative consequences, and they do so for a good reason. If you fail to manage your payments properly, you will face a certain risk.

  • Each time you apply for a loan, your credit score will be slightly reduced. This means that the more loans you have applied for, the lower your score will be.
  • Your loan applications can reduce your credit score. This is why you shouldn’t go around applying for random loans without actually checking eligibility criteria and your financial situation.
  • In case you default on your loan, this is a red alert to creditors. This is obvious, but we still want to mention it. If you don’t make timely payments, you can get into a debt cycle.

How to Avoid Decreasing Your Credit Score?

A personal loan is not a bad thing in and of itself. When you take out a loan, it probably won’t have a long-term negative impact on your credit score.

The most important factor is your payment history because it makes 35% of your FICO score.

This means that if you make your payments on time and in full, your credit score will not suffer. In fact, you can even improve it if you pay off your loan flawlessly. The more payments you make on time, the better your score will be.

If you pay your loan and credit cards regularly, you will increase your credit score.

However, should you miss any payments on your personal loan, you will be penalized. To prevent damage to your credit score, make sure you pay your loan on time.

How Can Personal Loans Help?

In most cases, a personal loan is an unsecured loan that you can pay off in fixed monthly installments. Since your monthly installments are fixed, you will not collect as much debt as you would with a credit card or other revolving loan types.

You can use personal loans at your discretion. You will not be asked about the purpose of your loan. You can also use a personal loan to consolidate your debts since they are available at lower interest rates.

However, if you decide to do this, make sure you don’t balance the credit cards you are paying off.

Debt consolidation will not take all your financial burden off your back, but it can still improve your credit score. Your new loan’s interest rate must be lower than your existing debt.

If you use your personal loan for debt consolidation, you will have to take care of just one loan instead of juggling a few of them. Also, if you cannot pay off your entire debt, a single lender can often provide a better deal.

All in all, if you can make payments on time and manage to pay off your loan within the anticipated time period, you will show that you can handle debt responsibly. After you pay off your loan, you can ask your lender to report positive credit history. This is a sign to lenders that they can trust you, and it will increase your credit score for all future loans.

Conclusion

Who would think that a loan can actually help you improve your credit score? Well, now you know that it can.

You can use personal loans for many purposes: debt consolidation, medical expenses, refurbishing your home, and many more.

If you have a good credit score, you will be able to get a personal loan quickly and easily. But you can also improve your score if you pay off the loan on time.

On the other hand, if you have many debts, taking out a personal loan can help you turn them into one and pay them off more easily. However, before applying for a loan, it is important to know your credit score, shop around for loans, and carefully read all the loan terms.

If you follow all the tips we listed and paid off your loan on time, you can improve your credit score and increase your chances to get personal loans and other types of loans in the future.

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