Does Taking on a Personal Loan Affect Your Credit Score? When it comes to paying for some of life’s biggest expenses — a home renovation, a big medical bill, an emergency, a wedding, or even a funeral — many people find themselves short on the cash needed to cover these costs right away.
A personal loan is a form of credit that can come in handy in these instances. And according to a 2019 Experian study, personal loans are the fastest-growing form of debt in the U.S. But when it comes to taking on any form of additional debt, consumers should take time to think about how this new line of credit can affect their financial life, including their credit score.
So does taking on a personal loan impact your credit score positively or negatively? Really, it depends.
Why Use a Personal Loan in the First Place
Personal loans generally allow you to borrow money at a much lower interest rate than if you were to put the expenses on a credit card. According to the Federal Reserve, the current average APR for a two-year personal loan is 9.58%. By contrast, the average interest rate on a credit card is 16.30% but can be as high as 24%. So a personal loan can be a cost-effective way to cover a big expense or consolidate debt.
How a Personal Loan Can Help Your Credit Score
Taking on a personal loan can help improve your credit mix. Your credit mix refers to the different types of credit accounts you have, including credit cards, loans, mortgages, etc., and it makes up 10% of your credit score.
While it’s not necessary to have one of each type of account, having a variety of accounts can show lenders that you have the ability to manage multiple types of credit. This can help you, as financial institutions are more likely to see you as a more creditworthy borrower when you apply for a new form of credit, like a mortgage or car loan. (Just make sure you’re not taking on too much debt.)
Personal loans can also help you establish a track record for making on-time payments. Payment history is the most important factor in calculating your credit score — it makes up 35% of it. Making your monthly payments on time and in full can provide clues to a lender that you are very likely to continue paying back the money you owe, should you apply for another line of credit in the future.
This is especially important when you’re just starting to build or improve your credit. In fact, while a low credit score is typically a roadblock to getting approved for most loans, some lenders actually offer personal loans that are geared toward people with fair or bad credit.
Upstart, for example, accepts applicants with a credit score of 600 or below and even those whose credit history is so insufficient that they don’t even have a credit score.
OneMain Financial Personal Loans also offer an option for those with fair or poor credit. Before you apply, just keep in mind that taking on a personal loan with poor credit means that you may pay higher interest rates and some fees.
How a Personal Loan Can Hurt Your Credit Score
Of course, as with any form of credit, irresponsible use of a personal loan can have a negative impact on your credit score. And much like with any other loan, mortgage, or credit card application, applying for a personal loan can cause a slight dip in your credit score. This is because lenders will run a hard inquiry on your credit, and every time a hard inquiry is pulled, it shows up on your credit report, and your score drops a bit.
As a result, you may want to be strategic when you decide to apply for a personal loan. Applying for a personal loan soon after applying for a new credit card could cause an even bigger drop in your credit score since a hard inquiry would be run for both applications.
Many lenders offer an online tool you can use to figure out what interest rate you’d likely qualify for based on your information. Getting an estimate won’t hurt your score, and you can be sure you’re getting the best interest rate before you submit your application.
Another thing to keep in mind is that personal loans can be really useful tools for debt consolidation and paying off debt. However, the habits that got you into debt in the first place can cause a personal loan to feel more like an extra financial burden.
For example, if you take on a personal loan to pay off a maxed-out credit card but then go ahead and max out the credit card again immediately after, you’ll be stuck with more credit card debt and a personal loan to pay off.
This debt cycle can also negatively impact your credit score if the burden of extra payments is so high that you begin missing monthly payments or don’t make payments in full which hurts your credit utilization ratio.
Always make sure you have a plan to pay off any additional debt you take on before you even submit your application. And getting to the root of any not-so-healthy financial habits can ensure that you actually solve the problem instead of just managing a symptom of the problem.
A personal loan can be an affordable way to fund a large expense, cover an emergency, or even consolidate debt. But much like with any other form of credit, its impact on your credit score can depend on how it’s used.
A slight dip in your score after applying is generally to be expected since a lender will run a hard inquiry on your credit. But using a personal loan to diversify your credit mix and making on-time payments toward your balance can have a positive impact on your score.
Frequently Asked Questions
1. Will applying for a personal loan affect my credit score? Yes, applying for a personal loan will result in a hard inquiry on your credit report, which can cause a temporary dip in your credit score.
2. Can a personal loan help improve my credit score? Yes, making timely payments on a personal loan can help establish a positive payment history, which is a crucial factor in determining your credit score.
3. What should I consider before applying for a personal loan? Before applying for a personal loan, consider your ability to repay the loan, the interest rate and fees associated with the loan, and how it fits into your overall financial plan.
4. Can a personal loan be used for debt consolidation? Yes, personal loans are commonly used for debt consolidation as they can help simplify multiple debts into a single payment with a potentially lower interest rate.
5. How can I avoid negative impacts on my credit score when using a personal loan? To avoid negative impacts on your credit score, make sure to make your monthly payments on time and avoid taking on excessive debt that you can’t afford to repay.
Originally posted 2023-07-06 10:02:14.