Whether it is to consolidate your debt, refinance your credit card balances, or pay for a medical emergency, people take out personal loans for all sorts of reasons. While a personal loan might increase your debt, it doesn’t automatically translate to a decrease in your credit score. How your credit score is affected by a personal loan depends on a variety of factors. In this post, we’ll explore these factors and even see how personal loans can be used to improve your score.
Understanding Credit Score
Your credit score is a metric that measures your level of creditworthiness. One of the most commonly used scores by lenders is FICO. FICO score ranges from 300 and 850. The calculation of your FICO score is based on five factors with different weights. These factors include:
- Payment history (35%)
- The total amount of outstanding debt (30%)
- Length of credit history (15%)
- New credit (10%)
- Credit mix (10%)
Borrowers with scores less than 580 are considered high risk and may have trouble securing loans or might have to compensate for the risk with higher interest rates. Scores above 670 are considered good and favorable, while scores over 800 are considered exceptional.
Why People Take Out Personal Loans
Unlike mortgages or auto loans which are designed for specific purposes, personal loans can be taken to cover just about any expense. These might be expenses arising from an emergency, like a medical bill or the repair of a leaky roof during the rainy season.
Savvy borrowers use personal loans to lower interest rates on credit card payments. How? Since personal loans typically have lower interest rates than credit cards, using a personal loan to clear off your credit card debt will leave you with a reduced amount to pay in interest.
Before lenders grant a personal loan, they assess your credit score, and a host of other factors to determine your ability to pay back. If you’re creditworthy, your loan is likely to get approved.
How Personal Loans Can Boost Your Credit Score
Taking out a personal loan can improve your credit scores in the following ways:
- Improving your credit mix
As identified earlier, 10 percent of your FICO score is determined by your credit mix. This means having a variety of credit helps improve your score. Since you have to pay off your loan in monthly installments, it is tagged as an installment loan. If what you currently have are revolving debts like credit cards, then adding an installment loan will improve your credit mix, and, in turn, boost your credit score.
- Enhancing your credit history
Credit history measures how you’ve handled debt payment in the past. The idea is that borrowers that have handled debt very well in the past will do so in the future. Therefore, if you make your loan payments on time, it further contributes to positive payment history. This, in turn, improves your score.
- Reducing your credit utilization ratio (CUR)
Credit utilization ratio measures how much of your available revolving credit you’re currently using. Since personal loans are not factored in when calculating your CUR, a personal loan that’s used to pay off revolving credits (like credit card debt) will reduce your CUR. A lower CUR invariably improves your credit score.
How Personal Loans Can Hurt Your Credit Score
While personal loans can boost your score when used wisely, it can also hurt your score. Here are some of how this can happen:
- Hard inquiries on your credit report
When shopping for a personal loan, most lenders only carry out soft inquire. But before a personal loan is approved, most lenders will carry out a hard inquiry on your credit. A hard inquiry will negatively impact your score, albeit by a few points. However, when you have several hard inquires on your credit within a short period, it might indicate that you’re hard-pressed and in dire need of multiple loans. This may result in a major dip in your score.
- More Debt
Personal loans that are used to pay medical bills or cover a vacation expense simply increase the total amount of outstanding debt you have. While some people use a personal loan to clear off credit card debt, it’s a matter of time before they max-out their credit card again. This means they now have two debts to pay: credit card debt and personal loan. Having more debt negatively impacts your credit, especially if you fail to make payments on time.
When Taking a Personal Loan Makes Sense
As you can now see, a personal loan can either help or hurt your credit score depending on how you use it. We’ve listed some scenarios where taking out a personal loan makes sense. However, note that this list is neither written in stone nor exhaustive.
- Paying off high-interest debts
A personal loan (with a low-interest rate) used to pay higher interest debts will reduce the total amount you’ll have to repay in the long run.
- Costly emergencies
Financial experts will always tell you to an emergency fund. However, if a costly emergency arises that’s more than the amount you have reserved in your emergency fund, then taking out a personal loan is preferable to using a credit card.
- Home remodeling
You might think that a home equity line of credit (HELOC) is more appropriate. The issue, however, is that to secure it, you need to use your home as collateral. Personal loans, on the other hand, are unsecured, so you do not have to risk losing your home.
When it comes to taking out a personal loan for things like a vacation, a big event, or a costly wedding, ensure that you are fully equipped to make monthly payments till you clear off your debt. If not, saving more money or getting a better paying job might be a smarter move to ensure you can afford it. The last thing you want is to add another debt burden on your shoulders for something that can be avoided or postponed.
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