How Do Personal Loans Affect Credit Score?

How Do Personal Loans Affect Credit Score a.k.a. your FICO score? Conceivably, a personal loan can solve a whole host of financial problems for you when you are in need.

However, a personal loan can also impact your credit score either positively or negatively. So, knowing the risks and benefits before you apply for one is highly advisable. How do personal loans affect your credit score? Read on to find out.

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For starters, taking out a personal loan may affect your FICO score and make it more difficult for you to obtain additional credit in the short term.

On the other hand, paying off a personal loan in a timely manner should boost your overall score. Because it could be a good or bad decision, it is important to do your homework diligently before committing to taking on debt.

What Is a Personal Loan?

Personal loans are consumer loans that can be used for any purpose that you suits you, from starting a new business, to financing home repairs, or paying for an unexpected emergency.

A good personal loan typically has lower interest than the average credit card interest rates. For that reason, personal loans are often used to pay off or consolidate credit card or other high interest debt.

Beneficial personal loan terms are often offered by credit unions or, depending on the strength of your credit profile, by banks, peer-to-peer lenders, etc. Personal loans can be unsecured (i.e., requiring no collateral on your part), or secured. The latter makes it easier to get the loan approved.

Other factors that weigh in on your loan approval are the amount you’re requesting and your credit profile.

How Is Your Credit Evaluated?

Credit worthiness is rated by credit reporting agencies based on the following criteria:

  • Payment history (35%): i.e., are your payments made on time?

  • Amounts owed (30%): i.e., is the amount you used more than 30% of available credit?

  • Age of your credit history (15%): i.e., how long have you had your open credit lines?

  • Credit mix (10%): i.e., what type of loans is your debt profile comprised of?

  • Recent credit inquiries (10%): i.e., have you had any hard pulls indicating fresh attempts to obtain more credit?

In addition, derogatory marks to your credit profile such as charge-offs, liens, collections, repossessions, evictions or bankruptcies in the past several years will lower your FICO score and may negatively impact your chances for credit approval.

So, How Do Personal Loans Affect Credit Scores?

All other factors being equal, a personal loan per se only affects your credit score when you apply for the loan and thus authorize a hard pull to be performed to check your credit profile.

Depending on how good your credit profile is, the impact should be insignificant. If approved, the amount of your personal loan will not have a great or lasting impact on your FICO score.

Personal loans are fixed installment loans and are not accounted for in the same manner as revolving debt (e.g., credit cards or lines of credit).

For that reason, your loan should actually raise your FICO score if you use it to pay off or consolidate credit cards type debt. In other words, you would be lowering your credit utilization ratio (i.e., increasing your available revolving credit).

That said, whether used to lower credit card debt or for another purpose, your loan amount will be reflected in your new debt-to-income ratio calculations.

Therefore, other new debt such as mortgage loans, for which debt-to-income ratio is closely examined, may be transitorily impacted.

Is There a Downside to Taking out a Personal Loan?

As long as your repayment schedule is closely followed and your payments made on time, no negative effect should befall your credit profile. In fact, adding the loan to your credit mix diversifies the latter in a way that is desirable.

However, a personal loan remains debt that you contracted. It is imperative that you carefully consider whether you are capable of keeping up with the repayment schedule.

Ideally, monthly payments should be automated and not scrambled over every month when they are due. Otherwise, late or missed payments could turn your loan experience into a disaster for your credit score.

It is also crucial to avoid accumulating debt or to frivolously spend the proceeds of a loan just to be left with the burden of repaying huge obligations.

Pros and Cons of Personal Loans

Pros

  • Fixed installment payments with predictable repayment timeline

  • Lower interest rates than revolving credit loans

  • Straightforward and fast funding if your credit score is good (sometimes within 24 to 48 hours)

  • No collateral required. You can also provide collateral to ensure approval or larger loan amount.

  • Affordable monthly payments since loan repayment duration can range from 2 to 10 years

  • Freedom to use the money as you see fit, for any purpose you decide, and in whatever spending rate you prefer: slowly, over time, or lump sum

Cons

  • Well, it remains taking on debt, or more debt

  • Minimum payment on substantial loan can become a challenge

  • Less than adequate credit can make it difficult to be approved

  • Temptation to misuse the sizable amount of cash suddenly available

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