The Relationship Between Personal Loans & Credit Scores
Everyone runs into situations when a little extra money could be the difference between catastrophe and minor inconvenience. Personal loans can help you smooth over rough spots in your financial life or pay for large, otherwise unmanageable purchases.
An unsecured personal loan can ensure you have the available cash for tackling financial obstacles without collateral.
There are several ways your credit score and creditworthiness can be affected by a personal loan. There are also several ways that your ability to get a loan can be affected by your credit score.
We’ll explain how personal loans and credit scores affect each other here.
Getting a loan, or even applying for one, can have an impact on your credit score. Therefore, it’s important to know which credit factors will be scrutinized by a lender and how they can impact the lender’s decision about your loan.
Without knowing how your credit score is calculated, it can be difficult to understand which credit score factors are most important in determining whether or not you’ll qualify for a personal loan.
FICO credit scores are most often used to determine your creditworthiness by a lender. The factors affecting that score carry different weights, such as:
When a lender is considering you for a personal loan, they’ll most likely look at the length of your credit history, as well as how many new, or recently-opened, credit accounts appear on your credit report.
Keep in mind that some credit inquiries don’t show up on your credit report. These are called “soft inquiries,” and are typically carried out when you get a pre-approval notice from a credit card company or other lender.
Some credit report inquiries, like credit card and personal loan applications, create “hard inquiries,” which show up on your credit report and may impact your score, especially if you’re denied repeatedly.
While the drop will likely only be about five points per instance, hard inquiries can affect your ability to be approved for a loan, so be careful about frivolous credit applications.
Be aware that even when you’re approved for a loan, your credit score may dip initially. But, it will usually recover after you make a number of on-time payments on the debt.
Personal loans can have a very positive impact on your credit score, but only if you use them wisely. Some of the best ways to use a personal loan include consolidating debts, improving your debt-to-credit ratio, and reducing your overall debt more quickly.
Personal loans are part of a loan type called “installment loans.” This means that you owe a specific amount and you make equal monthly payments to the lender until the debt is cleared.
This differs from the debt type known as a “revolving account.” Revolving accounts are most common with credit cards, where your balance can fluctuate each month and your minimum amount due changes based on your balance.
Many people have a lot of revolving accounts without having any installment loans. This can have a negative impact on your credit score because your credit mix isn’t very good. Getting a personal loan can improve your credit mix and lead to an improved score.
However, if you don’t keep up on the payments – known as “defaulting on the debt” – then your credit score won’t see a boost from your personal loan. A good rule of thumb is to only take out a loan if the payment fits comfortably into your budget.
Debt consolidation is another great use of a personal loan. Consolidation means that you pay off current, higher-interest debts with the personal loan, then repay the personal loan, often at a lower interest rate than available on credit cards and other types of high-interest loans.
Paying off your credit cards can boost your credit score, but be wary of continuing to create new charges on those accounts. The whole point of consolidation is to get out from under the debt, not clear off your credit cards for another round of spending.
Your debt-to-credit ratio is how much credit you have available versus how close you are to those credit limits. This ratio accounts for about a third of your credit score with the three major credit bureaus – Experian, Equifax, and TransUnion.
Credit cards are the main concern here, as the closer you get to the credit limit, the more your credit score can be negatively affected.
Personal loans, being installment loans, are not usually counted in this ratio; using a personal loan to pay off those credit card balances and bring your debt-to-credit ratio under control means your credit score will likely get a boost with the major credit scoring agencies.
Even when installment loans are counted in the debt-to-credit ratio, they’re not generally as disruptive to your credit score as having high revolving account balances.
High interest rates can make it very difficult to pay down balances on existing accounts. If you’re just making minimum payments on your credit card balances, you’re going to end up paying a lot in interest charges. Using a personal loan to pay those balances means that they’re no longer accruing those high interest charges on a monthly basis.
While it’s completely possible to create your own plan for paying off those balances over, say, a three-year period, it’s also much easier to forego the plan when finances get a bit tighter.
Personal loans are usually set up to be repaid over that same three-year period, and they carry the benefit of keeping you on track because they can’t be stretched into decades like credit card balances can.
Once you’ve made the commitment to repay, it becomes just another monthly bill that doesn’t fluctuate and doesn’t allow you to fluctuate, either. Many borrowers find that extremely useful in budgeting.
There are plenty of great outcomes for getting a personal loan, but things can also go poorly if you don’t have a solid plan for repayment or you continue to accrue balances on your credit cards after they’re paid off.
Careful use of loans is essential to avoiding poor outcomes and lower credit scores, as is having a solid plan for your financial health.
Having your credit cards paid off doesn’t mean that you should close the accounts. It’s important to keep those accounts open so your credit score doesn’t take a hit.
It sounds counterintuitive, but closing those accounts can have a negative impact on your credit score. This impact is most noticeable when you close accounts that have been open for years; it drags down your credit history age and can lead to a much lower overall credit score.
Not only can the closures impact your credit history, they can also decrease the available amount of credit to which you have access, hurting your debt-to-credit ratio.
A zero balance on a card with a higher limit will usually lead to an improved credit score, but closing that account causes that card, with its zero balance and credit limit, to be removed from your credit report.
It’s also to your benefit to use your cards occasionally, but only for something you would have purchased anyway (think groceries or gas). Pay the card balance immediately to avoid interest charges and keep the account in good standing. Doing this will ensure that the issuer doesn’t close the account for inactivity.
Of course, some of the most egregious negative impacts from personal loans can occur if you fail to handle the loan responsibly. Missing payments, paying late, and otherwise failing to meet the terms of the loan can result in huge impacts to your credit score.
This is particularly true if you’ve never had an installment loan before. Failing to meet the terms of the agreement raises red flags with future lenders and can completely derail your chances of getting another unsecured loan.
A new loan of any type can also affect your credit history age, as it is a new credit account that gets added to the mix for figuring your credit history age. While the impact should be relatively minor, you should be aware of it and avoid applying for any other credit accounts for (at least) several months after getting a personal loan.
You cannot completely avoid this small hit to your credit score, but you can minimize it by maintaining your new loan responsibly and making payments in a timely manner.
The most important parts of protecting your credit score are:
These are the major factors in building and boosting your credit score; personal loans give you the opportunity to pay on time, reduce the balances on higher-interest instruments, and build a better credit profile.
However, personal loans also carry the possibility of reducing your credit score if you handle them poorly. Like any other financial tool, it’s the maintenance that matters. It’s likely that your credit will take a small hit if you’ve added another credit account. But, you have the ability to carry that forward into a higher score and better overall creditworthiness.
No loan has to be a constant drag on your credit; it’s in your power to be responsible and prove yourself worthy of the trust given to you by the lender. This will inevitably lead to an improved credit score, making you more attractive to prospective lenders for future financial needs.
Keeping your credit score as high as possible is easier when you know how to control your spending, create a budget, and act responsibly with the credit you already have.