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Suppose you are considering a home improvement project, such as new landscaping or the addition of a swimming pool, or you have medical expenses to cover. In that case, a personal loan might be a good solution. But how do personal loans affect your credit score? And the truth is that personal loans affect your credit score, but not necessarily badly. In fact, for responsible borrowers, personal loans can help improve their credit scores.
Highlights & Key Takeaways
- Personal loans have many advantages, such as the ability to help you consolidate high-interest credit cards into one loan with a lower payment and interest rate, the ability to build your credit history, and even the ability to take on a home project or go on that big vacation you have been dreaming of.
- Five primary factors that affect your credit score - Payment history (35%), utilization (30%), credit history (15%), new credit (10%), and credit mix (10%).
- Personal loans do not have an impact on credit utilization.
- As with any loan or credit card, the key is responsible borrowing.
Do Personal Loans Hurt Your Credit?
There are some factors related to personal loans that can directly hurt your credit score:
- Creating a hard credit pull: the creditor will conduct a hard credit check whenever you apply for a credit card or personal loan. This inquiry helps them to make a well-informed financial decision on your creditworthiness and whether or not to loan you money. And in doing so, your credit score will take a slight hit of up to five points.
- Increase your debt: a personal loan will naturally increase your debt. This results in an increase in your debt-to-income (DTI) ratio. And according to a 2019 Experian study, personal loans are the fastest-growing form of debt in the U.S.
- More monthly expenses: failure to make monthly payments can seriously impact your credit score. FICO and VantageScore, the two primary credit scoring models in the U.S., consider payment history the most important factor in calculating credit, making up 35% of your credit score.
- Increase your credit mix: creditors like to see a healthy mix of credit balanced across a mortgage or lease, automobile loan, credit cards, student loans, personal loans, etc. If you do not yet have any personal loans, applying for one can help your credit score; if you have one or more, it can work against you.
Personal Loan Factors That Don't Hurt Your Credit Score
Some personal loan factors have no impact on your credit:
Interest rates: have no direct impact on your credit score. This is good news because interest rates fluctuate up and down. If interest rates are down, it’s all the more reason to jump on a loan. If rates go up, it won’t hurt your score, but you need to be prepared as your monthly payment will likely be higher.
Term of a loan: terms won’t directly impact your credit score, but there is a peripheral effect. For example, if your loan is 60 months, it won’t cause any more dent or lift in your credit score than a 24-month term. However, paying your loan consistently and on time over 60 months could help improve your credit score.
Type of loan: doesn’t directly impact your credit score, with one exception: if you have too many personal loans, this can look poorly on your credit mix. It’s always best to diversify your credit without putting too many eggs in any one basket.
“To avoid a negative impact on your credit score, make sure you pay your loan on time every month. And, make sure that you don’t take out a personal loan if you don’t need one. Practice responsible borrowing.”
Do Personal Loans Build Your Credit?
Here are some ways a personal loan can help you build your credit.
- Establishes credit history: Taking out a personal loan is a great way to show creditors that you know how to borrow responsibly.
- Doesn’t impact your credit utilization ratio: Unlike a credit card, personal loans do not impact your credit utilization, comprising 30% of your credit score.
- Demonstrate good payment history: Payment history is the most significant factor in your credit score. So, when you pay your personal loan payment on time every month, it can help give your credit score a boost.
- Save you money: A popular reason borrowers take out personal loans is to consolidate high-interest credit cards. Personal loans offer funds in one lump sum with lower interest rates than you can get with a credit card. It makes it easier to make your monthly payments (fewer bills to stay on top of), and it can save you interest. You can save a bit each month as the consolidated monthly minimum due on your loan may be lower than your combined credit card payments.
- New credit inquiry: Though applying for a new loan will result in a hard credit inquiry, this isn’t always bad. Despite a slight ding of up to five points, the new credit inquiry can work in your favor over time. New credit applications account for about 10% of your credit score.
“Borrowing responsibly is the key to improving your credit score, lengthening your credit history, and letting a personal loan work in your favor. Any time you consider a loan, make sure you need it and ensure that you can pay your bill on time every month. Never apply for more than what you need and can pay.”
How to Monitor The Impact of a Personal Loan on Your Credit
Monitoring your credit score and credit report is an excellent practice for anyone that wants to stay on top of their creditworthiness. And personal loans for good credit offer lower interest rates and higher credit limits than loans for borrowers with fair credit. But part of protecting and improving your credit score requires a bit of diligence.
The best strategy to protect your credit rating is regularly checking your credit report and history. Credit agencies update their records once a month, which means your credit information can change regularly. So, take steps to check your credit score once a month. You can get a credit score from your credit card company, financial institution, or loan statement. You can also use a credit score service through Experian, Equifax, TransUnion, or a free credit scoring site.
Annually, you should also take a close look at your credit report. The best way to do this is by requesting your credit report through annualcreditreport.com or one of the bureaus. Per the Federal Trade Commission, U.S. consumers can access their credit reports for free once yearly.
When to Consider Taking Out a Personal Loan
Some of the best reasons to consider taking out a personal loan are:
- Debt consolidation: Credit card interest rates and minimum monthly payments can add up. According to the Federal Reserve, the current average APR for a two-year personal loan is 9.58%. The average interest rate on a credit card is 16.30%, but it can be up to 24%. Debt consolidation can save you money in your monthly payment, lessen the interest you pay over time, and improve your utilization.
- Emergencies: Despite our best efforts, emergencies can arise, and you may need some fast cash. Personal loans for emergencies can help cover auto repairs, medical bills, and more.
- Home improvement: We all want our homes to be the best that they can be. And with a home improvement loan and responsible borrowing, you can achieve just that.
- Weddings: The average cost of a wedding in the U.S. in 2022 was $30,000, which doesn’t include expenses like rings, wedding gowns, honeymoons, etc. A personal loan for wedding is a great way to achieve the wedding of your dreams.
- Vacations. U.S. vacation time is short compared to other countries. So, if you can swing the monthly payment of a vacation loan, it can help you take the vacation you have always wanted, creating priceless memories for you and your family or friends.
What to Consider Before Taking Out a Personal Loan
Aside from whether or not you can take on the responsibility of another loan, consider these seven parameters before taking out a personal loan.
- Loan features - This includes the term length, loan minimum, and maximums, and what the loan can and should be used for
- Interest rates and fees - Though an interest rate won’t directly impact your credit score, a higher interest rate usually translates into a higher payment. And a lower interest rate can mean a lower payment. But be sure to watch out for fees, too, including loan origination fees, early payoff penalties, and fees for missed payments.
- Qualification leniency - Understand any membership requirements, minimum credit score requirements, and co-signer/joint application optionality should you wish to have or need a co-signer on your loan.
- Application process - Remember that any time you apply for a loan, there will be a hard credit inquiry which can impact your score by up to five points. Aside from that, do your homework on the processing time/funding time for approved applications and any distinctively competitive offerings.
- Customer support - Find out the hours and how you can contact the lender for support should you need it. Look into chat options or if you can only email or call. Lenders that provide flexibility in their contact options are often more convenient than those that don’t.
- User reviews - Most lenders have a rating and reviews platform like Trustpilot that you can access to find out the satisfaction of other borrowers. If you see a lot of negative commentary on customer service, availability, miscommunications, etc., this might be something for you to consider.
- Perks bonus - As you research the above parameters, give the potential lender your own assessment regarding their flexibility, transparency, and technology. Those offering these things should rise to the top on your list of potential lenders.
Personal loans affect your credit score but don’t always negatively impact you. Responsible borrowing, such as good payment history, not taking out a loan more than you can handle, etc., can help you improve your credit score while allowing you to cover expenses or do something you’ve always dreamed of. Personal loans are a great way to develop and demonstrate your creditworthiness if you practice responsible borrowing.