If you’re interested in taking out a personal loan, you may be wondering if it will affect your credit score. The short answer is that a personal loan will affect your credit score – but if you are responsible with your borrowing, a personal loan can actually improve your score. Are personal loans ever bad for credit? Yes, they can be: If you fail to make payments on time, a personal loan may have a negative effect on your credit score. But with the right planning and information, this is a situation that you can avoid. Let’s take a closer look at how credit scores work and how a personal loan can affect your credit.
How your credit score works
Your credit score is a number that lenders use to predict your future credit behavior, including your likelihood to pay back a loan on time. Your credit score is calculated using information from your credit reports. Credit reports track your credit history over approximately the last 7 years, and they are compiled by three main credit bureaus. These bureaus are called Experian, TransUnion, and Equifax. It’s important to understand the factors that go into determining your credit score. Let’s look at what information is often included in credit reports and then how that information is weighted when calculating your score.
Information typically included in your credit reports:
- The current amount of debt that you have not yet paid back
- Your history of paying bills
- The amount of loan accounts you have, and what types of loans they are
- The amount of time you have had loan accounts open for
- Your credit utilization rate
- Credit utilization rate is the total amount of credit card debt that you currently have divided by the total amount of credit available to you. For instance, say that you have 2 credit cards. One card has a total available credit of $800 dollars, and you are using $300 of what is available. The second card has a total available credit of $1000 and you are using $250 of what is available. Your credit used amount is $550, and your credit available amount is $1800. $550 divided by $1800 gives you a credit utilization rate of 30.5%. It’s generally recommended that you keep your credit utilization rate below 30%.
- Records of any bankruptcies that you may have had, or debts that are in collections
- “Hard” credit inquiries (These are situations when a creditor looks at your credit file in order to determine how much risk there is in loaning you money. They happen when you apply for a loan.)
This information is then combined to calculate your credit score. The formulas can vary a bit, but generally five factors are weighted in the following order of importance:
- Your history of making payments
- The amount of money you currently owe
- The length of your borrowing history
- The “credit mix” of sources you have borrowed from (ex. mortgage, credit card, auto)
- Recent hard credit inquiries
The most commonly used type of credit score is FICO. Your FICO credit score will be a number from 300-850. The higher the number, the easier it will be for you to qualify for a loan and receive a favorable rate of interest. A score of 720 or above is considered to be good credit, while a score of below 630 is usually considered to be poor credit.
What is a personal loan?
A personal loan is money that you usually borrow from a lender in a lump sum and then slowly pay back over time by making monthly or biweekly payments. Personal loans can be used to pay for a wide variety of different expenses, including vehicle repairs, home improvements, debt consolidation, weddings, and parties. Personal loans are offered by lenders, banks, and credit unions.
Personal loan vs. credit card
Personal loans are different from using a credit card. With a personal loan, you receive a lump sum of money up front and make regular payments on the loan that are all of the same size. With a credit card, you borrow different sums of money each time you use the card, and your payment size each month changes based on how much you have borrowed during that specific period of time. Usually, personal loans have lower interest charges than credit cards. It’s been shown that people can pay off a personal loan faster than they can pay off credit card debt.
How a personal loan can affect your credit
While a personal loan can be a very helpful tool, it’s important that you borrow responsibly and are aware of how personal loans can affect your credit. Here are a few of the ways that a personal loan can negatively impact your credit if you aren’t careful:
- Creating a hard credit inquiry: During the loan application process, lenders will run a “hard” check on your credit. A hard credit inquiry lowers your credit score for a few months. The more hard inquiries you have on your credit report, the more your score is negatively impacted. When shopping for a personal loan, it is best to complete all applications within a 1-2 week period. When there are several hard credit inquiries within a short period of time, they are usually only considered as a single inquiry by credit agencies. This is because they understand that people may apply with multiple lenders and shop around in order to find the best personal loan terms.
- Digging yourself deeper into debt: The amount of debt that you have affects your credit score. By taking on a personal loan, you are taking on more debt – so if you already have other significant sources of unpaid debt, this can negatively affect your score.
- Late payments and fees: If you fall behind on personal loan payments, this will be noted in your credit report and result in a lowering of your score. Additionally, failing to make payments on time can mean paying late fees and more interest over the course of the loan, causing you to get further in debt.
How a personal loan can build your credit
If used properly, a personal loan can help you improve your credit. Here are some of the ways that a personal loan can build credit:
- Broaden your credit profile: The types of debt that you have can influence your credit score – having a broader range of debt sources can help show your creditworthiness.
- Establishing a credit history: Making payments on time has a positive impact on your credit score. And having a long history of making consistent payments also is good for your credit. A personal loan allows you to do both of these things.
Deciding on a personal loan
Feel like you have a better understanding of how personal loans affect your credit? Great! At Sun Loan, we’re here to help you establish credit and have access to the funds that you need. Our experienced team will work with you online or in-person and put together a payment plan that fits your specific situation. Learn more and get started today!
