Did you know that there are 20.2 million people that have taken out a personal loan in 2020?
With the average size of a personal loan being $6,382, you may be wondering if taking out a personal loan is the best financial move for your current situation. If you struggled with a low credit score or finally got in your credit score up to where it needs to be, you could be unsure how a personal loan will affect your credit score.
That’s why today, we’ve created this complete guide to help you understand how a personal loan affects your credit score. Keep reading to learn more!
What Is a Personal Loan?
A personal loan is very different than a mortgage loan for a home or an auto loan. This is because a mortgage loan and an auto loan are designed for a specific purchase, whereas a personal loan can be used for almost anything that you need extra cash work.
Some people take out a personal loan to start their own business. Other people will take out a personal loan to finance an emergency car repair or even pay for their wedding.
The majority of personal loans on the market will have a lower interest rate than a credit card. This is also why many people choose to use a personal loan to pay off a credit card that they have a lot of debt on or another type of debt with a high-interest rate.
Personal loans are unsecured, which means that you wouldn’t have to put up any collateral for the loan. This is also what makes personal loans so different than mortgage loans and auto loans.
Depending on the credit score you have and how much of you’re looking to get from a personal loan, the terms of the personal loan will greatly vary.
How a Personal Loan Can Help Your Credit
There are many ways that a personal loan can help to improve your credit score. Some of the ways that you will find that a personal loan will prove your credit score includes:
A Balanced Credit History
Having a variety of different types of credit accounts will greatly help to improve your credit score. Since a personal loan is a type of installment loan, future lenders will see that you can pay off both revolving credit and installment loans.
Another way that a personal loan can improve your credit is by showing that you can make consistent payments. Every payment you make towards your loan will show that you can repay a loan and do so on time.
Making each personal loan repayment in full by the end of every month will create a positive payment history for you. Over time, this will help you to develop an increased credit score.
Reducing Your Utilization Ratio
A personal loan is a type of installment loan, which means that you pay off the loan’s entirety in inconsistent monthly installments. This means that the personal loan won’t affect your utilization ratio on your credit score.
A credit utilization score is how much credit you have available compared to how much of that credit you’re currently using. Many people will use a personal loan to pay off their revolving credit, such as auto loans, credit cards, and other types of revolving debt.
Doing this will help to greatly increase their credit scores by reducing their overall credit utilization ratio.
How a Personal Loan Can Damage Your Credit Score
Just as much as a personal loan can help to boost your credit score, it can also damage your credit score. Here are some of the downsides that you may experience when you take out a personal loan:
Many personal loans come with late fees or origination fees. If you aren’t careful with consistently keeping up the payments that come with your personal loan, there may be additional fees for your total loan.
You may want to consider understanding all of the fees that come with your personal loan before applying to one. In some situations, you may need to borrow extra on a personal loan just so that you can cover all of the fees that come with it.
A Change to Your Credit Report
For you to apply for a personal loan, a lender will take a look into your credit history and credit score.
This means that you will have a hard inquiry on your credit report, which will show up on your credit score and credit history. A hard inquiry does it hurt your credit score.
A change in your credit score as a result of hard credit inquiries will only impact your score for a few months. However, if you make multiple hard inquiries to your credit report within a short time frame, your credit score will see a lot of damage.
If you’re in a situation where you have to apply to multiple lenders for a personal loan, you may want to consider making all of your applications than the span of a week. This will minimize how much of a negative impact fee hard inquiries have on your credit score, since updated credit models will you please hard inquiries as rate shopping. Rate shopping won’t impact your credit score as much as hard inquiries over a spread out time will.
Another problem that often arises with people that take out a personal loan is that it makes it easier for them to get into more debt.
For example, if you’re taking out a personal loan to pay off a credit card, do just that. However, don’t go back to utilizing that credit card and racking up more debt until you get your personal loan paid off.
You can easily be put in a situation where you max out your credit card again and still have to worry about paying your personal loan back if you aren’t careful.
Understanding How Personal Loans Affect Credit Scores
A personal loan is a great tool to have to reduce your total credit card debt, to improve your credit score, or to cover any unforeseen expenses that are frequently popped up. You should be aware of all of the benefits and consequences that come with using a personal loan if you aren’t careful with how you manage your finances.
Are you interested in taking out a personal loan to consolidate your debt? Click here to learn how we can help today.