Personal loans can offer the financial flexibility you seek. But, before you decide if taking out a personal loan is a good idea for you, it’s important to ask, “How does taking out a personal loan affect your credit?”
This article walks you through the world of personal loans and the nuances of their potential impact on your credit score as well as gives you tips on how to use your loan to help increase your credit score through key practices and industry-leading resources such as the MyScoreIQ FICO® Score Simulator.
What Is a Personal Loan?
A personal loan is a sum of money borrowed from a lender (such as a bank or a credit union) meant to cover all kinds of large personal expenses. All personal loans are installment loans, meaning they are paid back to the lender in regularly recurring payments over an agreed-upon period, often monthly over one to five years.
Most personal loans are unsecured lines of credit, making them more convenient for the borrower. However, some personal loans are secured. Secured loans require the borrowers to offer up collateral, such as a car or a house, while unsecured loans do not require this.
People often take out personal loans to consolidate their pre-existing debt into one monthly payment or to cover unexpected expenses like emergency medical bills. It is also common to take out a personal loan to pay off large expenses over time, such as weddings, home improvements, or moving costs.
Positive Effects of Personal Loans on Credit
Building a Positive Payment History
One of the most significant advantages of taking out a personal loan is the opportunity to build a positive credit history by simply meeting payment deadlines. When you make timely payments on your loan, it demonstrates your ability to manage credit responsibly.
As a result, this can positively affect your credit score. Creditors and credit bureaus view a consistent payment history favorably, which can significantly improve your creditworthiness.
Credit Mix and Diversification
Your credit score considers various factors, including your credit mix. Having a diverse range of credit types, such as credit cards, mortgages, and personal loans, can positively influence your credit score. Because personal loans are installment loans, they add diversity to your credit history by showing lenders your ability to handle different types of credit reliably. Installment credit (like personal loans) looks great to lenders in contrast with revolving credit (like credit cards).
Negative Effects of Personal Loans on Credit
Late or Missed Payments
Unfortunately, the positive impact of personal loans can be quickly reversed if you miss payments or make them late. Late or missed payments can result in negative marks on your credit report, which can negatively impact your credit score. Lenders and credit bureaus look at late or missed loan payments as a strong indicator that a borrower is unreliable when making payments.
This is why making loan payments on time is one of the most important factors in maintaining a good credit score. In addition to a drop in your credit score, late or missed payments also subject you to incurring late payment fees and penalty interest rates. These fees can add up quickly and make it even harder to meet your financial obligations.
Increased Credit Utilization Ratio
Another factor that can negatively affect your credit score is an increased credit utilization ratio. Your credit utilization ratio is the percentage of your available credit that you are currently using. If you use a significant portion of your available credit, it can result in a drop in your credit score. Personal loans can add to your total credit usage.
If you max out your credit cards while you have an outstanding personal loan, it can lead to a high credit utilization ratio, which will potentially have a negative impact on your credit score.
Applying for a personal loan can result in a hard inquiry on your credit history. While this is a standard part of the lending process, it’s essential to be aware that credit inquiries can temporarily negatively affect your credit score. Fortunately, this drop in your credit score is often small and not long-term.
However, lenders and credit bureaus may interpret multiple credit inquiries in a short period as a sign of financial distress, which can raise concerns.
Find Out How a Personal Loan Affects Your Credit with the FICO® Score Simulator by MyScoreIQ
Even with all this information on how personal loans can affect your credit score, taking the next step to apply for a loan can be daunting for new borrowers.
The FICO® Score Simulator by MyScoreIQ helps eliminate uncertainty by allowing you to simulate a variety of actions and see how they may affect your credit score. The FICO® Score Simulator does not change your credit scores or the information in your credit report; its simulations are kept private to you, making it completely risk-free.
You can get a strong idea of how a personal loan can affect your credit score and evaluate whether or not it’s the right move for you. If you are considering applying for a personal loan, this is an invaluable tool for you.
How to Manage Personal Loans Responsibly
If you plan to take out a personal loan, it’s crucial to manage it responsibly to help ensure it has a positive effect on your credit score. Here are some tips:
Budgeting is a fundamental aspect of managing personal loans responsibly. With a budgeting plan, borrowers can avoid taking on more debt than they can afford. This can lead to missed or late payments and, therefore, a drop in your credit score. Make sure you have a clear picture of your income, expenses, and how personal loan payments fit into the equation. That way, you can create a budget that accommodates loan payments and other financial responsibilities.
Make Payments On-Time
Consistently making on-time payments is the foundation of a healthy credit score. When you take out a personal loan or another form of credit, lenders and credit bureaus closely monitor your ability to repay that debt as agreed upon.
Making payments on time demonstrates your financial responsibility and reliability, which, in turn, has a positive impact on your credit history. This is why it is always important to hold yourself accountable for making your payments on time using whatever method works best for you, whether that’s setting monthly reminders for yourself, automating your payments, or making an effort to align all your monthly payments on the same day.
Pay Off Loans Early or as Agreed
While making on-time payments on your loan is essential, there are times when it is even better to pay off your loan early. Paying off your personal loan early has its advantages, such as reducing interest costs and improving your financial flexibility.
However, it’s equally important to proceed with caution and fully understand the terms of your loan agreement. The priority is to always abide by the terms of your agreement with the lender. Ensure that you make payments as agreed to avoid a negative impact on your credit.
Personal loans can have both positive and negative effects on your credit. Your personal loan’s ultimate effect on your credit report depends on how responsibly you manage it.
When handled wisely, personal loans have the potential to be a significant asset for your credit profile. Making your payments on time, month after month, is a testament to your financial responsibility, a fact that credit reporting agencies acknowledge and appreciate. This consistency in payment history can elevate your credit score and improve your overall creditworthiness. Also, personal loans can diversify your credit mix, another credit scoring factor that lenders can favor. A varied portfolio of credit types, such as personal loans, credit cards, and mortgages, is seen as a positive sign, demonstrating your ability to manage different forms of credit.
However, not all aspects of personal loans are beneficial. Late payments can be particularly damaging, sending negative signals to creditors and causing a drop in your credit score. Likewise, excessive credit inquiries during the application process can temporarily lower your credit scores, signaling potential financial instability. Additionally, high credit utilization, a result of maxing out credit cards while having an outstanding personal loan, can adversely affect your credit.
To gauge how a personal loan might affect your unique credit situation, you can turn to tools like the FICO® Score Simulator from MyScoreIQ. This simulator allows you to model different financial scenarios, including the impact of taking out a personal loan. It’s a valuable resource that empowers you to make informed financial decisions.