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How Do Personal Loans Affect Credit Score
Tips for Using Personal Loans to Build Credit
Things to Consider Before You Borrow Money
Improve Your Credit with Strategic Borrowing
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Personal loans can be used for many purposes — from debt consolidation to emergency financing. However, they can have a negative impact on your credit score if you approach them carelessly.
In this blog post, BadCredify will explain how exactly personal loans can help improve your credit score when used responsibly, as well as how misuse can harm your rating. By the end, you should have a grasp on what you need to know before borrowing money and how it can impact your future creditworthiness.
Key takeaways:
- Through timely payments, personal loans can raise your credit score. They may also act as credit diversification and reduce your credit utilization rate.
- Hard inquiries (credit checks), high levels of debt, and missing payments will lower your overall score.
- A good way to responsibly use your personal loans is to budget, set up automatic payments, and align your loan with your credit goal.
- Before you apply, try to improve your credit score for better personal loan terms.
How Do Personal Loans Affect Credit Score
Let’s discuss how personal loans can sometimes help and other times harm your credit score.
When Are Personal Loans Good For Credit Scores?
At BadCredify, we’re dedicated to responsible borrowing. By following these guidelines, you can potentially enhance your credit score with a personal loan.
On-Time Payments
Your payment history is a huge factor in your credit. It makes up about 35% of your FICO score. Each and every on-time personal loan payment becomes a positive entry on credit reports.
Even with a late payment history on personal loans, you can still earn a good credit score by paying timely. Consistent on-time payments demonstrate to lenders that you are a responsible borrower, and sooner or later — your credit score will become higher.
Credit Mix Factor
Another factor that influences your credit score is your credit mix — the various types of credit accounts you have. Personal loans are considered installment loans, whereas credit cards relate to revolving credit.
If your credit history mostly consists of information on revolving credit, opening up an installment account, such as a personal loan, will be a great way to achieve diversity in a credit mix. This variety in your credit accounts influences about 10% of your FICO score.
Make Your Credit Utilization Ratio Lower
Credit Utilization Ratio is the percentage of revolving credit available being used in correlation to the total amount of available credit. This comprises roughly 30% of your FICO credit score.
The lower this percentage, the lower your dependence on revolving credit will be. You should try to keep your CUR below 30%.
How will a personal loan help? You could consolidate your high-interest credit card debt through it. This would lower your credit utilization rate and increase your FICO score over time.
When Are Personal Loans Bad For Credit Scores?
Personal loans affect your credit score in a bad way, too, when you mistreat your debt responsibilities. In order to keep your FICO credit score in good shape, you should avoid the steps below.
Hard Credit Checks
A personal loan application will require a hard credit inquiry because it assesses a borrower’s ability to repay. A hard check might lower your credit score for a short duration. One inquiry will likely not lower your score by many points (typically up to 5), but multiple inquiries within a short period of time could do so.
The inquiry will stay on your credit report for two years, but the effect on your score lessens with time. This means that an individual should have as few hard inquiries as possible. This can be done by applying for the loan only in case of need while giving some space between each application.
Increased Debt
When you obtain a new personal loan, it’s added to your current debt load. That additional debt will become a financial burden with poor management and can negatively impact your credit rating. Review your budget to determine if you can comfortably afford to make your payments before applying for a new personal loan.
Missed Payments
Missing payments on a personal loan will severely damage a credit score. They are sent to the credit bureaus and stay on your credit report for up to seven years. This could mean that getting a loan in the future becomes very tough. Even if you get one, it could probably be with high interest as you will be considered a risky borrower.
Tips for Using Personal Loans to Build Credit
Personal loans can be a great tool for building credit, especially if you’re new to borrowing. Check out these tips for effectively improving your credit.
Organize Your Budget
Having a budget ensures you can live within your current means. It will enable you to channel your income in a way that will meet your most vital expenses, which include settling your repayment obligations without overreaching financially.
How to Create a Budget
- List all sources of income.
- List all monthly expenses — including loan payments.
- Subtract your expenses from your income.
- Adjust your spending to the remaining amount.
Pay More Than Minimum
A personal loan is meant to be repaid with the principal plus any amount of interest on the loan. The loan principal is the original amount of the loan prior to making any repayments. Each monthly payment lowers your principal balance until the loan is repaid in full.
Accrued interest is the sum that is added over time to your loan amount. By paying more than the minimum, accrued interest gets minimized — so you can eventually pay off the loan a lot sooner. This will also show lenders you’re in a good financial shape, potentially resulting in a credit score boost.
Set Up Automatic Payments
Missed payments can be avoided by setting automatic payments. This will maintain a good payment history, and your credit score could be increased. In fact, most lenders will allow borrowers to set automatic payments to get their money timely throughout the loan life. Some will also offer interest rate discounts.
Consider Your Credit Goals
Consider the long-term financial plans you have and how a personal loan can be of help. Make sure that new debt furthers your purposes in the long term and doesn’t take away from realizing your credit goals.
For example, if you hope to build credit so you can eventually apply for a mortgage — taking out a personal loan and repaying it in a way that builds credit can be a big help.
Things to Consider Before You Borrow Money
Before you decide to borrow money, it’s crucial to fully grasp what’s involved with any loan. Pay close attention to these details to choose the right loan offer.
Interest Payments
Interest rates are a very important component of personal loans. The total amount paid throughout the term of the loan depends on the interest rate, the principal amount, and the length of the loan. It directly influences the monthly payments and the cost of the loan.
The interest rate on a personal loan may be either fixed or variable. At a fixed rate — you are charged the same percentage for the whole length of the loan. Under variable rates — the rate fluctuates according to the market conditions. They often start lower than fixed rates but can go up — making them a bit riskier.
Annual Percentage Rate
The APR incorporates the interest rate that is provided with it and then it adds the fees that are to be recovered by the lender — thus representing the real costs of the loan. It gives you an opportunity to compare loans and see which one will be cheaper. Aim for a l,oan with the lowest possible APR.
Repayment Terms
Repayment terms show how long you repay the loan and when you pay. These terms vary from a few months to many years. Term length affects your monthly payments and total loan cost. Shorter terms mean higher payments but lower costs. Longer terms mean lower payments but higher costs.
Savings Accounts and Personal Loans
A savings account also serves as your backup emergency fund, cushioning you against expenses that might eliminate the need for personal loans. Building savings involves setting aside money and then depositing it into the savings account you’ve opened.
It is wise to save money that will cover three to six months of living expenses. This financial cushion may help you avoid taking on debt to pay for unexpected expenses.
Does Getting a Loan Affect Your Credit Score? — Conclusion
Personal loans may leave a positive or negative impact on your credit score. Responsibly paying on time, holding several kinds of credit accounts, and maintaining a low credit utilization ratio can enhance your credit score. Overborrowing, initiating multiple hard inquiries, and having missed payments will weaken your credit score.
FAQ
Your credit might drop by a few points when you apply for a personal loan, though missed payments can cause a much steeper loss. At the same time, a personal loan will add to the amount of debt owed — which forms another part of your credit score.
Making on-time and consistent payments on your loan could be helpful in building credit. The credit mix section of your credit report also gives you points for responsibly handling installment loans. The credit mix represents 10% of your FICO credit score.
Learn more:
Personal Loan Eligibility Requirements
What Credit Score Is Needed For A Personal Loan?
Is A Personal Loan Variable Or Fixed Rate?
External sources:
Consumer Financial Protection Bureau