How Does A Personal Loan Affect Your Credit Score?
By Sa El
Last updated 12/29/2019
Summary: Depending on how you use your personal loan it can either help or harm your credit.
Figuring out how a personal loan will affect your credit score before you actually apply for anything is essential.
But here's the thing,
There are only a few things that can actually happen and they can be easy to avoid once you know them.
In this post today I will go over how a personal loan can either help or hurt your credit score and when it's the best time to apply for a personal loan.
What Is A Personal Loan?
A Personal Loan is one of the most versatile loan products because you can use them to pay for pretty much any (personal) thing.
They can be used for things such as vacations, medical bills, home repair, starting a business, or consolidating your debt.
Once your personal loan has been funded, you will be required to make fixed payments every month until the loan is paid off.
Once the loan has been paid, the loan can no longer be used again, which is why personal loans are a type of installment loan.
The terms and rates you will receive will be determined for the most part which personal loan you will qualify for by credit score.
What’s An Installment Loan?
An installment loan is a type of loan that allows you to borrow a large amount of money and requires that you pay back a fixed number of payments.
Other examples of installment loans are auto loans and mortgage loans.
Personal loans can be much easier to qualify for since they are typically unsecured.
Personal Loans Are Usually Unsecured
You will also find that personal loans can be much easier to qualify for since they typically are unsecured.
An unsecured loan is one where you don’t have to put up any collateral to get the loan funded.
However, you should have a pretty good credit score because that is what banks or lenders will use to determine the funding of your loan.
How Your Credit Score Works?
Two primary credit scores are being used at the moment, the VantageScore and the FICO Score.
Currently, about 90% of all lenders are using the FICO score, so you probably will want to focus on the FICO Score when trying to determine your actual credit score.
The score ranges from 300 to 850, and the higher the score, the better.
Each credit score system uses certain factors to come up with your actual score; below are the factors for your FICO score and how much each element affects your score:
Payment history (35%)
So, the reason people keep going all bonkers about "pay your bills on-time" is because your payment history accounts for a HUGE chunk of your credit score.
It is essential that you pay your bills on time and don't have any late payments.
Getting a 30, 60, or 90 day late on your credit can make it super hard to obtain credit for several years.
Having a good payment history is where you should put 95% of your focus.
Credit utilization (30%)
The next most important factor is how much of your credit you are actually using.
Using more than 30% of your credit is usually seen as high credit utilization and you will start to immediately see negative affects on your score.
Your goal should be to keep each individual card under 30% utilization and keep your overall credit utilization under 30%.
Length of credit history (15%)
This is one of the only factors in your credit that you have no control over.
Your length of credit history, or average age of accounts is something that is calculated based on your oldest account.
Every time you add a new account to your credit report, it will decrease the average age of your overall accounts.
The longer credit history you have, the better your score will be.
Always ask your creditor which credit scoring method they use before you apply for credit.
Credit mix (10%)
Having more than one type of credit is also important, you can have installment loans, revolving loans, auto loans, mortgages, and personal loans.
It's a smart move to have different types of credit so that your score can keep going up.
New credit (10%)
You want to keep your new credit at a low amount. The more new credit you have, the lower your score will be.
Usually any account younger than 6 months is considered a new account.
When you are dealing with your FICO score, just focusing on the above metrics will really help you increase your score and qualify for better rates.
Ways A Personal Loan Can Help Your Credit
Getting a personal loan can really help increase your credit score depending on how you use it; below we show you a few ways:
Increasing Your Credit Mix
As you can see from above, credit mix is one of the factors that can help improve your credit score.
Of course, this means having a credit card, a store card, a personal line of credit, and an auto loan are all different mixes of credit.
The more variety of credit you have on your report, the better your score can become.
History Of On-Time Payments
On-time payment is a huge factor when it comes to computing your credit score, and the more of them you have, the better your score.
Having a positive payment history is one of the few items you can control when it comes to your credit score.
It is essential that you only take out a loan if you can afford the payments.
Lenders will usually extend you credit based on what other lenders have already trusted you with.
Decreasing Your Credit Utilization
As an installment loan, a personal loan will not be counted when it comes to your credit utilization ratio.
This means you can see a massive jump in your credit score if you use the personal loan to pay down your credit card debt and lowering your overall utilization.
The lower your credit utilization, the higher your credit score can become, you might even be able to get a much lower interest rate on the personal loan as well.
Can A Personal Loan Hurt Your Credit?
Yes, if you don’t respect your personal loan it can wreak havoc on your credit score, some things you can’t do anything about and others you should avoid at all costs:
Decreasing Your Average Age Of Accounts
When you get approved for new credit, and it finally reaches your credit report, you will see a decrease in what is known as your average age of accounts.
Your length of credit history is another significant factor in your credit.
It is one factor of your credit that you have absolutely no control over outside of not obtaining new credit.
Just remember when you apply for this new personal loan, once it hits your credit, you will probably be dinged for having a lower average age of accounts.
Hard Inquiry On Your Credit
Whenever you submit an application for any type of credit, the lender is going to check your credit for approval.
Probably 80% of the time, you are going to get a hard pull on your credit, especially when you are looking into a personal loan.
Inquiries are one of those things that will negatively affect your score, and usually, you see an immediate change in your score when you get one.
Now, the good news is that they only last on your credit report for 2 years, but FICO only considers them for up to 1 year.
That is why it is best to just apply with as many lenders as possible on the same day.
This means everything will fall off at the same time, and you can get the best rate.
Missing Your Payments
Yes, here it is again, the age-old “don’t miss any payments” verbiage.
But, the truth is that people just sometimes forget to make their payments or situations happen that don’t allow you to make your payments.
If this happens, and you get a 30 day late on your credit report, it’s going to really mess your credit up for at least 2 years.
Whatever you do, don’t miss any payments!
When Should You Get A Personal Loan
While there are a ton of reasons you can get a personal loan for, you probably should only consider one for specific situations, and we list them below:
Paying Off High-Interest Debt
The thing about credit cards is that they all have different interest rates, and the more you use them and increase your utilization, the lower your credit score goes.
This is where using a personal loan to consolidate your high interest debt can really help you out.
The idea is to get a low-interest personal loan, enough to cover all of your credit card debt, and then pay off all the credit cards with the loan.
Not only will this put your credit utilization down to $0, but it will give you a lower interest rate on the credit and increase your credit score due to having a much lower overall utilization.
Capital For A Small Business
For me, this is probably the best reason to get a personal loan.
For most of us, going into the bank and walking out with a $5,000 loan for your small business is going to be 1000 times harder than it will be to get a $10,000 personal loan.
This is usually because these places want to know that your business idea is good, they want to see your entire credit history and to know you have some understanding of how your business works.
In all honesty, almost no one has that kind of information or experience when they are starting a business.
It’s best always to bootstrap your business in the beginning, and there is nothing better than a small personal loan to get things started.
You are getting a loan to create money, that’s the best thing I can think of.
Just the other day I was driving down the road and hit a pothole, this thing was almost invisible, and I found that other people ran over the same pothole.
Unfortunately, I wasn’t one of the lucky ones who got through it without issue.
Less than 3 minutes after hitting the pothole, I got an emergency alert on my car about tire pressure going down.
By the time I got home, my tire pressure was at 0, and the tire was flat; it cost me $500 to replace one tire, get an alignment, and have an inspection completed.
Luckily I have savings for stuff like this, but if I didn’t have anything saved, a small personal loan would have been a great option to get my tire fixed and be on my way.
If you have an emergency and need cash until you get through the crisis, I say go for a personal loan.
The purpose of a personal loan is to cover a large expense today that you can pay off over-time.
Depending on your income it may take you 1 year to save up $10,000 or to pay down $10,000 in credit card debt.
It makes more sense to obtain those things today with a personal and pay them back over-time.
Don't wait, if you need a personal loan you can get one by clicking here or check out a review of our best personal loans.