How Do Personal Loans Affect Your Credit Score?
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At a Glance
Your credit score is important and can affect a lot of things, such as whether you qualify for a loan or credit card and the interest rates, renting an apartment, landing a job, refinancing a loan, purchasing a vehicle, and even setting up utility accounts and paying for insurance.
There are also several factors that affect your credit score, including taking out a personal loan. However, it doesn’t always have to be negative. Read on to learn more about:
- What is a credit score
- How a credit score is calculated
- Factors that adversely affect your credit score
- Does applying for loans affect your credit score?
- What is a personal loan and what are its uses?
- What credit score is needed for a personal loan?
- How to improve your credit score through a personal loan
- How personal loans affect your credit score
What is a credit score?
A credit score is a number between 300 and 850 assigned to a borrower based on their credit history. The number depicts a consumer’s creditworthiness and how likely they are to pay back bills or a loan on time. Not only can lenders use your credit score to decide if they are going to approve your loan application, but it also can impact the interest rate you receive, as well as the credit limit on a credit card.
Technically, you don’t have “one” credit score because it depends on the data used to calculate it, and that may differ depending on the scoring model, the source of your credit history, and even the day it was calculated. There are three credit bureaus that calculate credit scores: Experian, Equifax, and TransUnion. Other companies that provide credit scores include FICO and VantageScore.
For lenders, a higher score means you’re more likely to be a low-risk borrower and repay the loan on time. A low score means you’re a riskier borrower and there’s a greater chance you won’t make the loan payments, so your application may not be approved, or you’ll be offered a high interest rate.
In most cases, score interpretations are:
- Above 750: Excellent
- 650-749: Good
- 550-649: Average
- Less than 550: Poor
How is a credit score calculated?
Credit scores are calculated slightly differently between the three credit bureaus, but there are a few factors that are consistent in calculations.
1. Payment history
Payment history is how you’ve repaid your credit in the past. This includes loans and credit cards, and considers any late or missed payments, bankruptcies, and collection information, as well as foreclosures and wage attachments. Payment history has a big impact in determining scores, sometimes up to 35% of the score.
2. Used credit vs. available credit
Another factor is how much of your available credit, or your credit limit, you are using. This is because lenders want to see you’re responsibly able to use credit and pay it off, not just max out your limit, which can indicate the ability to spend but not repay. Typically, 30% of your score is based on the total amount of your outstanding debt.
3. Credit mix
Your credit score calculation will consider the different types of credit you have, such as revolving debt (credit cards) and installment loans (mortgage, auto loans, student loans, personal loans). This includes how many of each account type you have. Your credit mix can show lenders you’re able to manage multiple accounts of different types of debt. 10% of your score is based on the credit mix.
4. Length of credit history
This details how long your different credit accounts have been active. It includes how many new accounts you’ve opened recently, as well as how long your oldest account has been open. Fifteen percent of your score is based on the length of your credit history, and 10% is based on any new debt or newly opened lines of credit.
5. Hard inquiries
A hard inquiry happens when a lender or creditor checks your credit due to a credit application. This can be for a credit card or loan, and many hard inquiries can impact your score. However, don’t let this discourage you from shopping. If you have multiple inquiries within a short period of time, they are typically counted as one inquiry.
Factors that adversely affect credit score
Knowing how a credit score is calculated is an important part of managing it. And, while scores can be calculated differently, a few factors that can negatively affect your score and you should avoid include:
- Late loan or credit card payments
- Missed loan or credit card payments
- Too many requests for new lines of credit
- Filing for bankruptcy
- Keeping a large or maxed out balance on credit cards
- Closing a credit card with an outstanding balance
- Closing older accounts (shortening your length of credit history)
- A short credit history, or none
- Too few types of credit
Does applying for loans affect your credit score?
As noted above, applying for and getting a personal loan can affect your credit score. This happens for a few reasons:
- Applying for a loan triggers a hard credit inquiry, which decreases your score by a few points for a short period of time.
- Your total outstanding debt has increased.
Because your overall credit history has such an impact on your score, lenders will take other factors into account when determining whether your loan application will be approved. For example, they will want to ensure you have a history of managing debt, make payments on time, and have a good credit mix.
What is a personal loan and what are its uses?
A personal loan is a type of financing you can get from a bank, credit union, or online lender. They can be used for just about anything, including paying for:
- Large purchases
- A wedding
- A vacation
- Medical bills
- Home improvements
- Car repairs
- School-related expenses
- Debt consolidation
These loans are a type of installment loan, meaning you make monthly payments to pay them off over time. They are typically unsecured, meaning you don’t have to provide collateral, and have fixed interest rates. This makes your monthly payment the same, and it’s easier to work into your budget and calculate when the loan will be repaid. Their interest rates can also be lower than other alternatives, like credit cards, though that can depend on your credit score, history, income, and other factors.
Related: Everything You Need to Know About Personal Loans
What credit score is needed for a personal loan?
The credit score you need to be approved for a personal loan varies by lender, but the higher your score, the more likely it is that you’ll be approved and be offered more favorable terms. Most lenders prefer a borrower to have a credit score of 670 and above as this is the best indication that the borrower is creditworthy.
However, you may find lenders, especially online lenders, that will accept scores as low as 600, or even down to 580. However, borrowers with these scores may not have as good terms, and interest rates may be high.
Related: Credit Score Required for a Personal Loan
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How to improve your credit score through a personal loan
Depending on your situation, taking out a personal loan can improve your credit score. Primarily, making your payments on time each month will boost your payment history. If you take out a loan to consolidate your credit card or other debt, you will be lowering your credit utilization which can improve your score.
If you don’t have any other credit, a personal loan can help you build your credit profile and lengthen your credit history. Additionally, adding a personal loan to your credit mix can show you’re able to handle a variety of credit products.
The most important things about using a personal loan to build credit are:
- Make your payments on time each month.
- Only take out a personal loan if you need it, and only borrow the amount you need.
- Compare lenders to find the best interest rates, terms, and features, and get prequalified where you can.
- Create a budget to ensure you can repay the loan.
Related: How Personal Loans Can Improve Credit
How personal loans affect your credit score
Applying for and taking out a personal loan can both decrease or improve your credit score, depending on how well you manage the loan. It’s inevitable that the hard credit inquiry when you apply will lower your score by a few points for a short period of time and will remain on your credit history for two years. However, if you make your payments on time each month and pay off the loan over time, you may see your score improve.
On the other hand, if you make late payments or miss payments, your score will be negatively affected. If you default on the loan and it’s sent to collections, or you have to file for bankruptcy, your score will be seriously impacted and may drop by dozens or even hundreds of points. That’s why it’s important to only take out a loan if you know you can afford it, and only borrow what you need.
When you first apply for a personal loan, it triggers a hard credit inquiry that will decrease your score by a few points for a short period of time, typically a few months. While it will remain on your credit report for two years, your score will quickly rebound. The only other reason a personal loan will hurt your credit score is if you make late or miss payments.
If you manage your personal loan responsibly, it should not affect your ability to take out a mortgage. However, if you have multiple personal loans, aren’t making payments on time, or you have too much other debt, your mortgage may be denied.