How Personal Loans Affect Your Credit:
Positives and Negatives
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Your car broke down and the mechanic gave you an outlandish estimate to fix it. You were hit with an unexpected medical emergency expense. Your credit card spending has gotten out of control. You’re strapped for cash and just don’t have enough to pay your bill all at once.
Now what can you do? Could taking on a personal loan help you out with these problems?
You’re probably here to find that out.
Most of us find ourselves in a position at some point in life where we just don’t have enough cash on hand. Whether it’s for a major life milestone, debt consolidation, or a large unexpected bill, a personal loan is a viable option to get you over this hurdle.
Personal loans can be used for a variety of reasons or purposes, and there are both risks and benefits. A personal loan can affect your credit. Some aspects can help raise your credit score, while other aspects can hurt your score, so it’s important to know how before applying for one.
In this article, we’ll go over the details of personal loans, types of loans, factors that affect your credit, and how you can borrow responsibly to improve your financial future.
What is a Personal Loan?
Personal loans are individual consumer-level loans that can be used for most any reason. You may want one for medical bills, home repair, starting a new business, making a large purchase, or debt consolidation.
Personal loans can have a fixed or variable interest rate, but they have a set term, meaning you’re expected to pay the debt in full by a specific date.
Personal loans can range from $500 to $100,000 depending on your financial situation and needs.
You can get a personal loan from a bank, credit union or online lender. Good credit is not always required, but it can be helpful for faster approval and lower interest rates.
Personal loans are installment loans, so they’re not considered in the credit utilization ratio. Carrying a debt on a personal loan does not negatively affect your credit in the way having outstanding debt on a credit card would.
When to Use a Personal Loan?
As stated above, personal loans can be used for pretty much whatever you want. That being said, if you’re in the market for a personal loan, you should have a specific reason why you want one.
Here are some of the biggest and best reasons people take out personal loans:
- Debt consolidation. Using a low-interest personal loan to pay off higher interest debt or combine debts into one payment can be a smart way to increase your credit score. TransUnion released a study in 2019 which showed that up to 84% of consumers who used a personal loan to consolidate their debt gained 20 more points on their credit score within three months.
- Pay off credit cards. According to the Federal Reserve, outstanding consumer credit as of October 2019 is a staggering 1.09 trillion dollars. To make it worse, credit cards typically have the highest average interest rate, between 15 – 20%. If your credit card has a 15% APR, and you can get a personal loan at 7% interest, you can cut your costs and save up to 50% on your payments. Need help paying off your credit cards? See our guide to get out of debt fast.
- Medical bills. If you’ve been hit with a large medical bill and don’t have the cash to pay it off, obtaining a personal loan is a much better option than applying the balance to a credit card, or the alternative, having your bill sent to a collection agency.
- Home repair or improvement. If you own a house or have a mortgage, you could get a Home Equity Line of Credit (HELOC). However, doing so would require you to put your house up as collateral, meaning that if you miss payments, the bank would own your house. A personal loan allows you to use it for home upgrades at a good interest rate without any collateral.
- Life events. Some people opt for a personal loan to finance their weddings, vacations, or other milestones in life. While this may not be the smartest option, if you are a responsible spender, it can certainly ease the burden having an affordable monthly payment rather than spending all that money at once.
Secured vs Unsecured Loans
Since personal loans give you access to funds to use at your discretion, and for any purpose, they are typically unsecured. What unsecured means is that you aren’t required to put down collateral to qualify or obtain the loan.
What is collateral?
Collateral is an asset that a lender accepts to ensure repayment of a debt. If the borrower defaults on their payments, the lender will seize the asset to recoup the balance of the debt.
Loans that require collateral are called secured. Some examples of a secured loan would be a mortgage, or auto loan, but you can also offer collateral to obtain a secured personal loan.
Because secured loans provide a back-up way for the lender to recover payment, they are less risk for them, making a secure loan easier to obtain. It also means secure loans are typically a lower interest rate than unsecured loans.
How Credit Scores Work
Your credit score is created from information on your credit report. There are three major credit reporting bureaus: TransUnion, Experian and Equifax. The most common score is your FICO score, which ranges from 300 – 850. Lenders and creditors use this score to evaluate your creditworthiness. The higher the score, the better.
There are five main categories used in determining your credit score, and how it’s weighted:
- Payment History (35%): The biggest factor in your score is how well you make your payments on time. All payments on loans, lines of credit, and credit cards are recorded. Payments made on installment loans do take a bit more precedence in this category than payments on revolving debt.
- Outstanding Debt Owed (30%): This is the combined total amount of all debts owed, and also the percentage of your credit utilization ratio. As your total debt decreases, your score should go up.
- Length of Credit History (15%): This is the age of your oldest credit account (the first time you ever applied for a loan or credit card), and the average age of all your credit accounts. The longer you keep your accounts open, the better it is for your credit score.
- Types of Credit (10%): Also known as your credit portfolio. If all you have is a credit card, then you don’t have a mix of credit types. Your credit looks better if you have a history of both installment loans and revolving credit, so opening a personal loan can help your score in this category.
- New Credit (10%): When applying for loans, a hard credit check is performed, which lowers your credit score in the short term. One credit inquiry isn’t going to hurt much, but if you apply multiple times in a short period, then your score can take quite a dip.
All that information goes through a mathematical formula that nobody seems to know, and voila, out comes your credit score.
Installment vs Revolving Debt
There are two types of credit: installment and revolving, and as seen above, it’s one of the factors in determining your credit score.
What is installment debt?
Installment debts are loans with specified monthly payments, paid off over a set amount of time.
Mortgage loans, auto loans and personal loans are examples of installment debt. Each has a fixed monthly payment, and a fixed term length and date for the debt to be paid in full.
What is revolving debt?
What is Credit Utilization and How Can I Improve it?
Credit utilization is how much of your available credit you’re currently using. As seen above, it counts towards 30% of your overall credit score. Interesting enough, the goal for credit utilization is also 30%. Anything above that amount, and it damages your credit.
Here’s an example:
|Amount of Debt Owed||Total Credit Available||Credit Utilization Ratio|
If you have $10,000 of available credit across all accounts, and currently have a total balance of $8,000 then your credit utilization is at 80%, far above where it should be, and likely hurting your credit score.
Lenders consider a high credit utilization ratio to be a high risk. It’s important to lower that below 30% as soon as possible.
These are some ways you can manage your credit utilization:
- Pay down your debt as fast as you can. Paying down your debt, and not accruing additional debt will continually lower your utilization ratio. You’ll also save money on future interest, so it’s a win-win.
- Ask for a credit limit increase. This may cause a hard credit check, but if successful, then just merely having a higher limit will automatically decrease the utilization on the amount you currently owe, and it should have a positive net result on your score.
- Make earlier payments or extra payments. Credit utilization is measured every month, so if you make earlier payments in the month, or split your payments in half and pay twice a month, you can stay ahead of that reporting cycle.
- Use different cards or accounts. You may have a credit card that’s your go-to for spending, and as a result, it may have a high credit utilization. Use a different card instead, so that ratio doesn’t increase, and start paying down the high balance card.
- Be an authorized user on someone else’s account. You may have a spouse or trusted person with a credit card or other account they don’t use much. If you are added as a joint user, that counts towards your available credit too. This is only a good idea if the other person has a low credit utilization, and someone with your utmost trust.
- Set up automated alerts. Be notified when there’s a change to your balance amounts, so you can stay on top of it and either make a payment or not charge more to that account.
- Use a personal loan to transfer and pay off revolving debt. Personal loans aren’t counted towards credit utilization, so every dollar you can transfer from a credit card to a personal loan is a dollar less towards your utilization ratio. Take our example above, with a total credit available of $10,000, and a current balance of $8,000. If you transfer $5,000 over to a personal loan, then the balance goes down to $3,000 and your credit utilization hits that magic number of 30%.
Everything you can do to keep your credit utilization in check can not only improve your credit score, but net you favorable terms towards future borrowing.
How Do Personal Loans Positively Affect Credit Score?
There are many positives when applying for a personal loan.
A personal loan can be a quicker way to decrease debt: A lower interest rate means more of your payment each month goes towards the principal amount, and not just paying on the interest. This means your total debt goes down faster. Less debt means a lower debt to income ratio, which can increase your credit score. Lenders also look at a lower debt to income ratio more favorably, and there’s a higher likelihood of loan approval.
Have a better credit mix: Personal loans give your credit the contribution of an installment loan. Having both installment loans and revolving debt on your credit report helps give a boost to your credit score.
Establish payment history: Regularly making your monthly payments on time gives your credit report a positive payment history. A report without delinquent accounts can increase your credit score, and keep your credit in good standing in the long term.
Lower credit utilization ratio: We covered this above, but since personal loans are considered installment loans and not revolving, it doesn’t factor into your credit utilization ratio. Using a personal loan to pay off revolving credit such as a credit card, can help give a quick bump to your credit score since it frees up all that reported debt.
How Do Personal Loans Negatively Affect Credit Score?
Any time you take on additional debt, there’s always a risk and things that can adversely affect your credit.
New inquiry on your credit report: Applying for any type of credit results in a hard inquiry check on your credit report, which negatively affects your credit score. However, this dip is only short term, and depending on the reason for your loan (like debt consolidation) it might even offset the decrease in score and go back up in the next month or two.
More debt: At the end of the day, applying for a loan means you have more debt that you’ll need to pay off. It’s important that you don’t get into bad spending habits. Say you have credit card debt you are transferring over to a personal loan. If you start maxing out the credit card limit again, then you’ll have both a credit card AND a personal loan to pay off.
Missing payments: Payments on a personal loan that are more than 30 days late can be reported to credit bureaus as a delinquent account. This can badly hurt your credit score. An account deliquent for 30 days can lower a credit score by a whopping 90 – 110 points. Avoid missing payments at all costs.
Additional fees: Personal loans do have interest, so whatever your loan amount, remember that it will end up costing you more than that before it’s paid off. There may also be other associated fees, such as an origination fee, or late fee. Make sure you are aware of any and all fees that may be involved. Being approved for a loan, then canceling it can hurt your credit. Having fees due that you didn’t know of, and not being able to cover them can also hurt your credit.
How to Borrow Responsibly
There are many benefits or reasons for taking out a personal loan, but it’s an important financial decision, and you should be prepared to take on the type of debt.
To borrow responsibly, think of the following things before applying for a loan:
- How will I spend the funds? It’s usually not a good reason to take on debt just for the sake of it. You should know why you want a personal loan. Generally, you can use a personal loan for any reason, but some lenders may ask you the nature of the loan, so you should be prepared to give some sort of answer. Having a plan also means you are more likely to only use the loan for your chosen purpose.
- How much money do I need? Once you know the purpose for your loan, you can calculate just how much you need to borrow. You may qualify for a larger loan, but you should only borrow the amount that you need. Once you pay that loan off, the lender will be trusting of you, and you can take out an additional loan then if needed. When deciding on the amount needed for the loan, you should also factor in the cost if there’s any additional loan fees from the lender.
- What monthly payment can I afford? A personal loan should not just be determined by the amount of money you need, but also by how much you can reasonably afford to pay each month. If you need $5,000 but can only pay $100 a month, then having a loan term of 1 year is just not feasible. When applying for the loan, let the lender know what you’re looking at for a payment each month, then figure out the loan term length based on that.
- Avoid creating additional debt. One of the most common reasons for taking out a personal loan is for debt consolidation, or transferring high interest credit balances to the lower interest loan. Doing so will free up the available balance on your credit card, but that doesn’t give you free reign to rack it back up again. That will only put you in a worse financial position than you were before. Use cash instead of cards and don’t take on more debt until the loan is paid off.
Only you can decide whether or not a personal loan is a right for you. Educate yourself and make a plan not only for your loan application, but also how you’ll repay the loan.
Personal loans can be an attractive and viable option for paying off unexpected expenses, consolidating debt, paying off credit card debt, or even holiday shopping.
Opening a personal loan will help raise your credit score in the long term if you responsibly make your payments on time. However, when first applying for the loan, you might see a dip in your credit score when the lender does a credit check. If you don’t make your payments on time, a personal loan can quickly cause problems for your credit score.
Some best practices when it comes to personal loans are:
- Only apply for the amount of money that you need
- Make sure your monthly payment is within your budget
- Use it to consolidate higher interest debt
- Use it to lower your credit utilization ratio
- Make on-time payments
Doing these things will be positive for your established credit, credit score and save you money over time. A personal loan is not an excuse to acquire more debt, but can be a great option for the person who has a plan to work towards financial freedom.
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