How Do Personal Loans Affect Your Credit Score?
Some big expenses in life are completely unavoidable.
Whether it’s medical costs, buying a car or paying for major home renovations, one day you may find yourself staring at a bill that you won’t be able to cover all at once.
That can be a stressful experience. When faced with those big expenses, your first instinct may be to pay for it with a credit card.
While that might seem like your best option, your debt will come with high-interest rates. Plus, the longer you carry credit card debt, the harder it is to improve your credit score.
Another option you might look into would be payday loans. But short term payday loans come with a painfully high-interest rate.
Ideally, you would avoid them at all costs because they put you in danger of being trapped in a never-ending cycle of debt.
Most financially independent people prefer to avoid borrowing money from friends and family to pay off large expenses.
Doing so could potentially damage to a relationship with a friend or family member if you’re not able to pay them back on time.
No matter what, dropping thousands of dollars on large life expenses is tough for many. That’s why personal loans are likely to be the best option.
How Much Does a Loan Affect Your Credit Score?
Personal loans impact your credit score the same way that most loans would.
To keep your credit score in good standing or to improve it, you simply need to make the required payments on time based on your loan terms.
Even if you can pay off the loan early without penalty, it’s a good idea to make monthly payments until the term is complete.
Why? Because this strengthens your credit history. Having a personal loan also adds a new type of credit to the “credit mix” factor.
Why Credit Scores Matter
A credit score is a number that represents your credit history that lenders use to determine how likely you are to repay debt.
It’s incredibly important because it affects major financial decisions from buying a house to getting a new credit card.
The higher your score is, the more options you’ll have for loans with much better rates. That’s why it’s crucial to keep your credit score in great health.
Credit scores from FICO, the Fair Isaac Corporation, are used by more than 90 percent of major US lenders.
We don’t know the exact formula that is used to create credit scores. But we know of the five factors that FICO and other credit bureaus use.
These factors are payment history, the amount owed, credit history, new credit and types of credit used.
Each factor carries a different weight in your score. Payment history is the most important while varying types of credit matter less.
FICO Credit Score Factors and Their Percentages
| FICO credit score factors | Percentage weight on credit score: | What it means: |
|---|---|---|
| Payment history | 35% | Your track record when it comes to making (at least) the minimum payment by the due date. |
| Amounts owed | 30% | How much of your borrowing potential is actually being used. Determined by dividing total debt by total credit limits. |
| Length of credit history | 15% | The average age of your active credit lines. Longer histories tend to show responsibility with credit. |
| Credit mix | 10% | The different types of active credit lines that you handle (e.g., mortgage, credit cards, students loans, etc.) |
| New credit | 10% | The new lines of credit that you've requested. New credit applications tend to hurt you score temporarily. Learn more about FICO credit score |
FICO scores range from 300 to 850, with 300 being the lowest.
These scores change based on your credit activity and ability to pay debt on time, such as credit card payments.
If you’re in the habit of paying your credit card in full each month without carrying any debt, then your credit score should already be in good shape.
Each score range indicates a different credit standing. For example, a FICO score between 650 and 700 would be considered fair.
However, different credit bureaus have different information on your credit file so scores may vary.
Credit Score Ranges and Quality
| Credit Score Ranges | Credit Quality | Effect on Ability to Obtain Loans |
|---|---|---|
| 300-580 | Very Bad | Extremely difficult to obtain traditional loans and line of credit. Advised to use secured credit cards and loans to help rebuild credit. |
| 580-669 | Bad | May be able to qualify for some loans and lines of credit, but the interest rates are likely to be high. |
| 670-739 | Average/Fair | Eligible for many traditional loans, but the interest rates and terms may not be the best. |
| 740-799 | Good | Valuable benefits come in the form of loans and lines of credit with comprehensive perks and low interest rates. |
| 800-850 | Excellent | Qualify easily for most loans and lines of credit with low interest rates and favorable terms. |
What is a Personal Loan?
A personal loan, also known as a consumer loan or signature loan, is an advance of money lent by a bank, credit union or financial institution that a borrower pays back in monthly installments over a fixed amount of time.
Personal loans are unsecured, meaning that instead of being held against collateral, the amount of money and interest rates available to you are based on your credit history and personal income.
These loans are optimal because they come with lower interest rates compared to paying back credit card debt and payday loans.
Plus, personal loans are paid back in monthly installments with a fixed interest rates, making them easy to fit into your budget.
What can they be used for?
Personal loans can be used to cover many different types of large expenses such as moving costs, buying a house, paying for adoption, a family or medical emergency, paying for a car and even debt consolidation.
Student loans are also considered to be a type of personal loan. The amount of money from a personal loan can range from $1,000 to more than $50,000.
While personal loans can also be used for expenses like weddings and vacations, these occasions can often put you further into debt because of seemingly never-ending costs that come with them.
Personal Loan Calculator
Curious how much a personal loan might cost you? Try our personal loan calculator to see how much your possible monthly payments and accrued interest could be:
How to get a Personal Loan?
Personal loans are easy to acquire no matter what your credit score is, but they require prior research.
However, your credit score can limit the amount you can borrow as well as the interest rate on the loan.
Lenders of personal loans are usually traditional banks and credit unions.
Before applying, the first step is to calculate exactly how much money you’ll need. Then, check your credit score for free to see what shape it’s in. Your credit score is a major factor in securing a personal loan.
Just like with any financial decision, it’s best to do your research on what banks or credit unions would best fit your financial needs.
Your credit score will determine what option is best for you. Each lender may vary, but in general, people with good credit and high income will get the lowest interest rates on their loans.
Credit unions, which are not-for-profit, are a good option if you’re credit is just okay and if you need a smaller loan under $2,500.
If your credit is poor, you may need to have a cosigner or use collateral to acquire a loan.
The downside to having a cosigner is that they have to be the safety net for any missed payments.
Interest rates for those with a poor credit score are high. You can avoid this situation by checking your credit score beforehand and work on improving it before applying for a loan.
Aside from credit scores, lenders use several deciding factors when it comes to personal loans including income, employment history, and debt-to-income ratio.
To apply for a personal loan, you need to have specific documents prepared.
They may vary depending on the bank or credit union, but they usually require pay stubs, recent income tax returns, verification of address, W-2 forms, a list of assets, income, monthly debt obligations and liabilities in a personal financial statement and identity documents like a passport.
No matter what, always do your homework before applying for a loan.
Compare rates between lenders and ask questions about the terms of their loans. Doing thorough research before getting a personal loan will save you money down the line.
What is the Repayment Process Like?
Most of the time, personal loans come with a fixed payment schedule. Depending on the terms of the loan, payments are made monthly, just like any other bill.
Setting up an automatic transfer to make payments on your personal loan makes the process even smoother. It also will ensure that you don’t miss any payments, which can damage your credit score.
In some cases, a borrower can pay off the loan early. However, it’s best to check if doing so is penalty-free. Some lenders charge fees for early payments. It all depends on the terms you set up with the lender.
The beauty of a personal loan is that they come with fixed interest rates, so the payment should be the same every month.
At first, the idea of being in debt to another lender in addition to a student loan or credit card debt can seem overwhelming. But in the long run, a personal loan can boost your credit score as long as you make payments on time.
Final Word: Should You take a Personal Loan?
When you’re strapped for cash in the face of a large purchase, personal loans are your best bet for your budget and credit score health.
Remember to always check your credit score first no matter what before deciding to take out a personal loan so you can plan accordingly.
Getting a personal loan without planning in advance or learning about different options at various banks and credit unions could end up costing you more.
Having the ability to boost your credit score by eliminating debt or fixing errors before applying for a personal loan will help you get lower interest rates and give you more options.
Set yourself up for financial success by staying in the know about your credit score, so you’ll be ready for whatever expenses come your way.
