Do Personal Loans Affect Your Credit Score?
Tuesday, Oct 24 2023
You’ve been hit with an unexpected medical bill. You’re looking to consolidate your debt. The roofer just gave you an estimate that’s twice as much as you expected. A personal loan could be the solution to these problems.
Personal loans are unsecured, meaning they don’t require you to put up any collateral. And they generally allow you to borrow money at a much lower interest rate than if you were to put the expenses on a credit card. The current average APR for a two-year personal loan is 12.7%. By contrast, the average interest rate on a credit card is 22.16%.
But do personal loans affect your credit score? Yes, they do, just like other forms of credit. Read on to find out how.
Why Do Personal Loans Affect Your Credit?
Unlike auto or home mortgage loans, personal loans can be used for just about anything you want, from a way to pay for major expenses to providing an option for debt consolidation and management. Like any other form of credit, a personal loan affects your credit score.
Long-term, depending on how you manage the loan, having a personal loan on your credit report may prove beneficial or harmful. That’s because they affect your on-time payment history, credit mix, credit utilization, and age of credit accounts – four of the five factors that impact your credit score.
How Personal Loans Can Positively Affect Your Credit Score
Beyond providing cash, personal loans can benefit you in other ways. Under the right circumstances, a well-executed debt management strategy can improve your credit score, making it easier to achieve future financial goals.
Personal loans can raise your credit score by:
- Building and Improving Your Credit History. Payment history is the most influential factor in calculating your credit score, accounting for 35%. Lenders look at your credit reporting to determine whether you pay your bills on time and how likely you are to repay a new loan. Personal loans can help you establish a track record for making consistent, on-time payments, and helping you repair bad credit.
- Diversifying Your Credit Mix. Your credit mix refers to your different types of accounts, such as loans, credit cards, and mortgages. It makes up 10% of your credit score. With a personal loan, you borrow and pay it back in equal installments over a fixed period. A credit card is revolving credit, meaning it can be used and paid down repeatedly. Having various types shows lenders you can manage different types of credit.
- Lowering Your Credit Utilization. Credit utilization measures the amount of money you borrow compared with the available credit you can access through credit cards, home equity lines of credit, and personal lines of credit. Lenders want to see utilization below 30%. Since a personal loan is an installment loan, not revolving credit, it doesn’t increase your credit utilization. But, if you use a personal loan to pay off credit card debt, it can lower your credit utilization.
How Personal Loans Can Negatively Affect Your Credit Score
While the notion of fast cash sounds nice, before you take out a personal loan, be sure you have a clear purpose and plan to repay it. This type of loan isn’t bad for your credit score in and of itself, but it’s still a form of debt. Irresponsible use can hurt your credit score like other debt.
A personal loan may negatively impact your credit score by:
- Digging You Deeper into Debt. Unless you intend to use the loan to consolidate, taking on a personal loan means more debt. If you already have other unpaid debt, it can negatively affect your score.
- Incurring Fees and Penalties. In the same way that on-time payments can boost your score, late or missed payments are reported to credit bureaus, lowering your credit for up to seven years. Missed payments can result in late fees, penalties, and more interest on the loan, leading to further debt.
- Creating Hard Inquiries. Like any other loan, mortgage, or credit card application, the lender will submit a hard credit pull when applying for a personal loan. This inquiry will result in a slight dip in your credit score. If you’re applying to multiple lenders to find the best terms, consolidate your applications in a few weeks to minimize the negative impact.
Key Facts to Consider
Why are personal loans appealing to many borrowers? They provide an affordable alternative to credit cards. It is a tool to help you finance life’s big purchases while saving on interest, but they aren’t necessarily the best solution for everyone.
Personal loans are most beneficial when you have a plan, like with any financial product. Whether you’re looking to consolidate debt, finance a home improvement, fund a vacation, or pay for a cross-country move, you must have a clear repayment plan before applying.
Keep a personal loan from lowering your credit score by making timely payments within the loan terms. If you decide to take out one, thoroughly research and compare all your options to qualify for the best possible loan.
Should You Take Out a Personal Loan?
Whether a personal loan makes sense depends on your finances. A personal loan could be the answer if you have the money to pay monthly. But a loan could get you in trouble if you live on a tight budget.
Scenarios where a personal loan could be your best option:
- Paying Off High-Interest Debt. As credit card balances have grown, personal loans have become popular to consolidate. Personal loans can assist with digging out of credit card debt quicker since they offer lower interest rates.
- Costly Emergencies. When an emergency strikes, a personal loan with lower interest rates and fixed payments can be better than putting the expense on your credit card. They offer short applications and quick decisions to help you effectively manage your emergency.
- Establishing a Credit History. A personal loan is an excellent way to start building your credit history. And if you have had financial road bumps in the past, they can provide an opportunity to rebuild.
- Paying Moving Costs. The average cost of a local move is between $822 and $2,544. You may not have cash available after a down payment and paying closing costs.
- Covering Wedding Expenses. From venue to dress to flowers and everything in between, weddings are expensive, averaging a $30,000 price tag. A personal loan to help make your engagement and wedding precisely how you always dreamed.
- You Only Have Revolving Debt. If you only have credit cards, a personal loan can add diversity to your current credit mix, showing lenders you’re financially responsible enough to handle a variety of debt.
The flip side is understanding where using a personal loan doesn’t make sense. While they offer a versatile option, there are expenses you shouldn’t fund with this type of loan.
Avoid using a personal loan to:
- Pay for College. Before considering a personal loan, exhaust options are available through scholarships, grants, and federal loans. Federal student loans don’t require a credit check and usually have lower interest rates.
- Fund Living Expenses. A personal loan can help you address a temporary hardship but could create a significant problem if you use it to cover day-to-day living expenses. Instead, look for ways to cut costs, like cooking at home, couponing, or canceling streaming subscriptions.
- Secure Investments. Investing proceeds from a personal loan may seem smart if you can get a low-rate loan and believe you will earn a higher return. But no investment comes with guaranteed returns, so you could risk losing the money and still having to repay the loan.
- Start a Business. A business or start-up loan may be a better option if you require funding for your business. Business loans are specifically designed for commercial use and are a better option.
- Finance a Home or Auto. Lenders have mortgage and car loan options to address these large ticket items better. Personal loans typically have higher rates than auto loans or mortgages, which are backed by collateral.
Getting a Personal Loan
A personal loan may be right for you. Depending on your unique situation, it may even help rebuild your credit score.
Focus Federal Credit Union is here to help you establish credit and have access to the funds you need by applying for a personal loan. We will work with you to create a loan management plan and discuss its impact on your credit score. Contact us to learn more.