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 even 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 the ways to get the most out of your loan.
What Makes up 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, each of them taking a share in your score.
These are the five credit score factors:
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.
Do you have a lot of debt? Of course, the less debt you have, the better off you are. It is best if you can 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 activity each month.
Credit mix refers to the types of different accounts making up your credit report. These include credit cards, student loans, automobile loans and mortgages.
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, there is no hard inquiry when you shop around for loans, 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 have a negative impact on your credit. Also, if you have a lot of new credit accounts, this can significantly reduce your score.
What You Need to 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.
Make sure you check your credit score before you start searching for a personal loan. You can do this very easily ‒ just 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.
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 and more flexible and you can definitely find a loan with favorable terms.
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 properly manage your payments, you will face a certain risk.
These are the risks associated with personal loans:
- 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.
- It is not only loan applications that can reduce your credit score, but loan rejections can do the same thing. 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 trap easily.
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.
Of all the credit score factors, the most important one is your payment history since it takes 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.
With a personal loan, the payments you make and the mix that your loan adds to your score are the most important factors. If you handle an installment loan and a revolving credit loan (for example, a credit card), you can increase your 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 Personal Loans Can 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 types of revolving loan.
You can use personal loans per your discretion. You will not be asked about the purpose of your loan. In addition, you can 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 run up fresh balance on 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. It is important that the interest rate of your new loan is lower than that of 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, in case 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.
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 additionally improve your score if you pay off the loan on time.
On the other hand, if you have a lot of debts, taking out a personal loan can help you turn them into one and pay them off more easily. However, before applying for the 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 pay 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.