Does a personal loan affect your credit score? More importantly, how does a personal loan affect your credit score? These are questions that often come to mind when applying for a personal loan. To understand how a personal loan affects your credit score, it’s important to first know how credit scores are calculated.
What Factors Go Into Calculating Your Credit Score?
Your credit score is a 3-digit number that reflects of how you manage your debt. Every debt-related action is assigned a certain score. Some actions carry more weight than others. These individual scores are added up to obtain your total credit score.
These are the five main factors that go into calculating your total credit score:
- Payment history – This takes into consideration how punctual you are with your credit card and loan payments. On-time payments will add a few points to your score. On the other hand, late payments will shave points off your score. Payment history is the single biggest factor that goes into your credit score calculation, accounting for 35% of the total.
- Credit utilization ratio – Credit utilization compares the amount of revolving credit you have to the amount you’ve already used. This only relates to credit cards. A low ratio will help build your score, while a high ratio could damage it. Credit utilization ratio is the second most important factor, accounting for 30% of your total score.
- Length of credit history –A longer credit history gives prospective lenders a longer time frame to assess your credibility as a borrower. 15% of your credit score is based on the length of your credit history. The longer your credit history, the better.
- Credit mix – This refers to the types of credit lines that you have open. Having various types of credit, including credit cards and loans, is good for your credit score. It shows lenders that you’re adept at managing different types of credit. 10% of your total score is based on credit mix.
- Newly opened lines of credit – When you apply for a loan, the lender typically does a hard credit pull to check your credit report before approving your application. Every hard check hurts your score by a few points. Taking too many loans or applying for multiple credit cards within a short window can damage your score significantly.
So how does a personal loan affect your credit score? Does a personal loan affect your credit score positively or negatively?
The truth is, taking out a personal loan by itself does not affect your credit score. It’s how you manage the loan and the loan payments that will boost or hurt your score. Here’s what you should know.
3 Ways A Personal Loan Can Affect Your Credit Positively
This may come as a surprise but there are several ways a personal loan can have a positive impact on your credit.
1 – Timely loan repayments can boost your score
You’ve seen that consistent on-time payments are the single biggest factor that affects your credit score. This includes payments on credit cards as well as all types of loans including personal loans. Making all loan repayments consistently and on time will strengthen your credit score by a few points every month.
Taking a personal loan is the easiest way to start building credit when you’re just starting your financial journey. The key to using personal loans to build your score is to be sure that you make all loan payments in full and on time every single month.
2 – Taking a personal loan can lower your credit utilization ratio
Credit utilization ratio compares the total revolving credit you have available to how much you use every month. A low ratio adds points to your credit score. However, if you tend to max your credit card regularly, your credit utilization will be high. This will hurt your credit score. One way to keep your credit utilization ratio low is by taking a personal loan.
Taking a personal loan increases the amount of credit available to you. Even if your monthly spending remains the same, the higher available credit will help to lower your credit utilization ratio. This is good as it will add a few points to your credit score. And because personal loans are not revolving loans, they are not taken into consideration when calculating credit utilization.
3 – Having a personal loan contributes to a better credit mix
Having a diverse portfolio that includes revolving and installment debt is good for your credit score. Revolving debt includes credit cards. Installment debt includes all types of loans such as student, home, vehicle, and personal loans. If you only have credit cards, taking a personal loan can diversify your portfolio and improve your score.
2 Ways A Personal Loan Can Affect Your Credit Negatively
1- Late payments can hurt your score
If consistent, timely payments on personal loans increase your credit score, stands to reason that late payments will hurt it. Even one late payment will shave a few points off your score. Multiple late payments can cause your credit score to drop drastically.
Worse still, you’ll pay a late fee fine and interest on late payments. These will push you further into debt and make the subsequent payments even more unaffordable. It could take quite a while to overcome the impact of a late payment.
2 – Applying for a personal loan can impact your credit score
Did you know that simply applying for a personal loan can affect your credit score? When you submit your loan application, the lender will request the credit bureau for a copy of your credit report to assess your creditworthiness. This is known as a hard credit check. Every hard credit check deducts a few points from your total score.
A single check won’t have a major impact on the score, but applying for more than one loan will make a significant difference. If you’re looking for the best rate when it comes to a personal loan, make sure to work with lenders that agree to do a soft check.
So How Does A Personal Loan Affect Credit Score – A Few Final Thoughts
A personal loan can affect your credit score in several different ways – some good, some bad. However, the loan by itself does not impact your score. What affects your score is how you manage the loan. Making all your loan payments on time every time will help to strengthen your score. The lower credit utilization and enhanced credit mix also help to boost your score. However, missed deadlines and excessive loan applications will damage your score.
Personal loans can be a real lifesaver. They allow you to borrow money quickly to cover emergency expenses. Unlike other loans, personal loans can be used for any purpose, from medical emergencies to home or vehicle repairs. Their lower interest rate also makes personal loans a cost-effective way to consolidate higher-interest debts such as credit card debt. Before you take a personal loan though, it helps to understand how it can impact your score both positively and negatively. This will help you enjoy the benefits while avoiding the pitfalls.
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