How Personal Loans Affect Your Credit Score
When considering borrowing, you may ask yourself, does a personal loan reduce credit scores?
Personal loans are very common, with most people borrowing from a lender at some point in time in their lives. Borrowing can affect your score in both positive and negative ways.
Borrowing money is not necessarily a negative thing, however your credit report will be impacted in the short term. It can also potentially hamper your chances of qualifying for a new loan until the time your existing debt is cleared.
When you make regular payments towards clearing your personal debt, your credit score gets a boost. Keep reading to explore how your score can either go up or down depending on how you manage your borrowing.
What Factors Into Your Credit Score
It is important to know how scores are calculated to understand how personal debt affects them. Lenders usually use the FICO score, which the Fair Isaac Corporation created. FICO scores range between 300 and 850 and are calculated based on the following five factors:
- Amount owed
- Payment history
- New credit
- Length of credit history
- Credit mix
Each of the five factors contributes percentage-wise in the calculation of scores. These percentages are according to FICO, so the exact percentages would differ for the three major credit checking agencies: Equifax, Experian, and TransUnion.
- 10% - credit mix, which is the number of open credit lines you have currently
- 10% - newly opened line of credit or a new debt
- 15% - comprises your account history’s length
- 30% - the complete amount of your outstanding debt
- 35% - your payment history
Does Applying For Personal Loans hurt Credit Ratings?
Receiving a personal loan, either secured with collateral or unsecured, will affect your score in the short term. However, constantly applying for loans every few months, whether you intend to use them or not, can actually have an even more negative impact on your creditworthiness.
Every time you apply for funds from a lender, they run what is known as a ‘hard inquiry’ on your credit report. This inquiry is shown on your report for around two years and each inquiry can knock points off your score that take around a year to recover.
Remember that the hit your score takes when receiving a loan starts to be reversed by making repayments, whereas hard enquiries do not have an automatic solution for reversing the negative impact they have on your report.
How A Personal Loan Can Boost Your Credit Score
A personal loan can help you improve your score in a number of ways:
- When you have different types of debt, it can be beneficial for your score. A personal installment loan in which you make monthly repayments combined with regular use and repayments of your credit card (revolving debt) will boost your credit mix factor.
- Making timely payments establishes a positive payment history, which leads to your score getting a raise. Also, your utilization ratio does not get factored because it is an installment loan.
- When you borrow a personal loan to clear revolving debt, you replace revolving debt, which in turn lowers your utilization ratio, thus bettering your rating.
What Credit Score Is Needed For A Personal Loan?
FICO scores range between 300 and 850. You are more likely to get approved for a loan with favorable terms, including interest rates and repayment schedule, if you have a higher score.
Though lenders might have different criteria, the 670 mark is an important threshold for borrower creditworthiness, especially for lenders.
According to FICO, there are five categories: poor, fair, good, very good, and exceptional. The qualifying ranges are:
- Poor (<580): Lenders will consider you a risky borrower and getting a loan approved will be very difficult for you. In order to build a credit score, you can consider credit-builder loans that lenders offer for this specific purpose.
- Fair (580–669): The number is below average, but you may get approved with high interest rates.
- Good (670–739): This is a number that lenders begin to prefer, making it easier to get approved.
- Very Good (740–799): The number is above average and shows your dependability as a borrower.
- Exceptional (800+): An exceptional number like this will entitle you to the best loan rates and terms.
While the impact of taking a new personal loan can temporarily cause a dip in your credit score, on-time repayment and other good practices will help improve your score and give you access to better loan conditions in the long run.