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5 Ways Personal Loans Can Influence Your Credit Score
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A personal loan is money lent by a bank or other financial institution, which you pay back in monthly installments. Terms — the amount of time over which the loan is repaid — generally range from one to five years, and interest rates can be as low as 6% or more than 30%, depending on your credit score.
Speaking of your credit score: You’ll want a good one to get the best personal loan agreement possible. But the loan itself can also affect your credit in a variety of ways. Read on to learn more about how your credit score is calculated, and what that personal loan can do to bruise or boost it.
5 factors that determine credit scores
So what determines your credit score in the first place? FICO’s scoring model relies on the following five factors:
- Payment history. Whether you regularly pay your debts on time is the most important factor in your score, accounting for 35% of the total. Missed and late payments can have a negative effect on your credit score.
- Credit utilization ratio (total amounts owed). The amount of money you owe to your creditors versus the amount of credit available to you accounts for 30% of your score. Keeping low balances — or eliminating balances entirely — can improve your scores.
- Length of credit history. How many years you’ve had an active credit file and how long it’s been since your last transaction make up 15% of your score. A short credit history can indicate riskiness to credit bureaus, and thus lower your score.
- Credit mix. The number of different types of credit accounts you have — such as credit cards, auto loans, educational debt and mortgages — makes up 10% of your score. A more diverse credit mix might give your credit score an edge, but it’s not a critical determining factor.
- New credit and hard inquiries. How many times you’ve recently applied for new credit accounts for 10% of your score. Several applications for new loans or credit cards in a short period of time can indicate risk to lenders and may lower your score.
These factors are used to calculate a three-digit credit score that serves as a guide for potential lenders looking at a borrower’s eligibility. FICO credit scores range from 300 to 850 and are ranked as follows:
- 300-579: Very Poor
- 580-669: Fair
- 670-739: Good
- 740-799: Very Good
- 800-850: Excellent
5 ways personal loans can influence your credit score
The better your credit score, the more favorable your personal loan terms will be. Higher scores can get you lower interest rates, and if your score is too low, your application might be rejected outright.
But a personal loan will also have an impact on your credit score. Here’s how.
1. Payment history
If you pay the minimum amount or more on your personal loan on time each and every month, you’ll be adding a positive factor to your credit report. However, if you miss payments or make late payments on the loan, you could hurt your score.
2. Total amounts owed
Opening a personal loan will raise the total amount of money you owe creditors, which could change your credit utilization ratio significantly. A ratio of less than 30% is recommended to avoid hurting your credit score; generally, the lower you can keep this number, the better.
That said, if you use a personal loan to consolidate debt or pay off high-interest credit cards, the benefits could outweigh the drawbacks. For instance, if you took out a $10,000 personal loan to cover two high-interest credit accounts with balances of $4,000 and $6,000, you could save money on interest.
3. Length of credit history
Opening a new account of any type decreases the average age of your credit accounts, which can ding your score. But because repayment behavior and credit utilization have greater weighting in your score than length of credit history, this factor isn’t necessarily a dealbreaker.
4. Credit mix
If you don’t already have an installment loan, adding a personal loan to your credit portfolio will increase its diversity, which can make you a stronger applicant when seeking future credit accounts.
5. Credit inquiries
Most personal loans do require a hard credit inquiry — which differs from a soft credit inquiry in that it is reported to the credit bureaus and can affect your credit score, especially if you have many hard inquiries in a short period of time.
What to be aware of when getting a personal loan
When shopping for or repaying a personal loan, keep these tips in mind.
Avoid high-interest, ‘no-credit-check’ loans
Personal loans are issued by major banks and financial institutions — but there are plenty of other people out there who want to profit on your financial need.
Avoid payday loans, title loans and cash advances, particularly when they advertise quick funds with no credit check. These loans often carry exorbitant interest rates, sometimes as high as 400%. And if they’re not checking your credit, chances are they’re not reporting your repayments, either, which means these types of loans can’t help you improve your credit score.
Make payments on time, every time
As mentioned above, missing or making late payments can have a negative impact on your credit score, so be sure to make your personal loan payments in full each month.
Don’t overextend yourself
If you won’t be able to afford your loan payments, it’ll only add to the financial situation that caused you to seek out a loan in the first place. So before you sign any paperwork, sit down and review your budget to ensure you have a plan in place to make your loan work for you.
Bottom line: When used correctly, personal loans can be a boon
If you’re responsible with a personal loan, it can ultimately help repair your credit, particularly if you use it as a debt consolidation strategy. Personal loans often carry lower interest rates than consumer and retail credit cards, and they can help you get ahead of late and missed payments.
For more information on personal loans and to find one that’s right for you, check out this personal loan comparison tool from LendingTree. We can help you find the right financial product for your needs, whether you’re consolidating debt or funding a major purchase.