A personal loan can dramatically affect your credit score. Whether there is a positive or a negative effect is up to you. First, let’s get a firm grasp of what her credit score is and how it is determined. Then let’s get into how a personal loan can affect that score.
A credit score is a number that represents how creditworthy you are in the eyes of lenders. A lender is an institution that makes funds available to a borrower, (someone like you or I), with the expectation of being paid back. Examples of a lender in action include college loans, car payments, mortgage, etc… any funding that you have borrowed.
The credit score is determined by a handful of things, but put simply, the score represents how trustworthy you are in paying a lender back. Scores range from 0 to 850, but anything 700 and over is considered excellent. Generally, there are five factors that determine an individual’s credit score. These are:
- Payment history
- Amount owed
- Length of credit history
- Credit lines
- Credit mix
Payment history is essentially a check to see if you have paid debts late, or not at all. A perfect payment history would consist of on-time payments made in full, whereas A bad payment history would include missed or late payments. The amount owed is just that: a total of how much money you owe to lenders. Length of credit history is also self-explanatory. It represents how long you have had credit. Usually, it begins with one’s first loan and/or credit card. Good payment history with a low amount owed and a longer credit history would help a credit score tremendously.
Credit lines represent the maximum amount of money that can be charged to a borrower’s account. More often than not, credit lines are associated with actual credit cards, as opposed to something like a loan or mortgage. However, the same idea applies: larger credit lines with less borrowed against the maximum are ideal.
For example, if you have a credit card with a max of $10,000 but only have $1000 borrowed against it, you are in a very good situation credit-score-wise. Having the same max with $9500 borrowed is not good for a credit score.
Lastly, credit mix is defined as the types of accounts that make up your credit history. Some of the more common types of accounts are credit cards, automobile loans, college loans, mortgages, and other types of personal loans. More mixed credit tends to raise credit score.
Now that you have a good grasp on what a credit score is and how it’s determined, let’s briefly define what personal loans entail and then discuss how it affects credit score.
A personal loan is any loan from a lender that establishes credit for the borrower. Put more simply, its money you borrow from a lender for personal use, whether it be for a car, a home, college, starting a business, investing, or even going on vacation, (although one would likely have to have a very good credit score for a lender to agree to a personal loan for a trip to the Bahamas!)
Personal loans are almost always unsecured, which financially speaking means that they are based solely on your creditworthiness, and do not involve collateral. According to Merriam-Webster, collateral is defined as “property (such as securities) pledged by a borrower to protect the interests of the lender”. In layman terms, collateral is something other than credit to pay back the loan if necessary.
A personal loan will affect your credit in all of the ways discussed previously. Provided you are responsible and timely with your loan, chances are it will help your credit score. However, the following will explain how a personal loan can help your credit and how it can hurt it.
Approximately 35% of a credit score is determined by payment history. This makes it the forerunner of credit score factors, the big kahuna, so to speak. On-time payments in full are crucial. Before applying for a personal loan, be sure that you can continue to make all of your other payments on time as well as the payment you are about to create for yourself. Even one missed a payment can take points off of your score.
Amount of Money Owed (Credit Utilization Ratio)
Another whopping 30% of your credit score is determined by the amount of money you owe. In the case of credit cards, ‘amount owed’ is more accurately known as your credit utilization ratio. Personal loans are not considered in the ratio, because they are installment loans, (repaid over time with a fixed number of payments). Credit cards, however, have maxes that can fluctuate.
Like we talked about before, it is good practice to stay well below your max on a credit card. That being said, if you, like many Americans, have more than one maxed out the credit card, a personal loan for debt consolidation can go a long way. A low-interest personal loan used for a high-interest credit card debt can help both your credit score and your credit utilization ratio.
Length of Credit History
First and foremost, if you take out a personal loan tomorrow, it is your newest line of credit. This means your credit history lengthens. For your credit score, this is good if you make good payments. A total of 15% of your score is determined by the length of your credit history.
Yet there is another factor that should be considered that relates to the length of your credit history: the credit inquiry. Nearly every time a borrower even applies for any type of loan or credit card, there is a credit inquiry, which can cost multiple points each and every time. Therefore, although it is recommended to shop for the best lender, beware of costly inquiries and ask necessary questions. Each inquiry can take up to five points off of your score.
Ideally, you want to leave gaps of time between lines of credit that you have opened. For example, a lender might see it as negative if you have opened multiple lines of credit over a short period of time. 10% of your credit score is determined by the length of time between lines of credit established. Obviously, life is random and constantly throws us curveballs, most of which cost money, but the ideal situation is to space your loans out.
We realize things are getting complicated. You should establish credit, but not that often and not without perfect payment. You should have a good mix of credit lines, but have time in between establishing them. The best advice is to make timely payments and make them in full. As long as you maintain a good budget, this is very possible.
That being said, lenders appreciate a borrower who is responsible for a good mix of credit lines. The remaining 10% of your credit score depends on it. Say for instance you have a college loan, a car loan, two credit cards, and a mortgage or a rent, and you pay all of them on time and in full. This is an excellent mix of credit.
More on Personal Loans
- If you have a bad credit score, (something in the range of 500-600), it can be cause for receiving a high-interest rate, if and when you secure a loan at all. Only apply for a personal loan with a bad credit score if you have a surefire means of paying it back quickly – preferably before the due date. As mentioned, a situation where this would occur would be taking out a personal loan to consolidate credit card debt.
- When shopping for a lender of a personal loan, pay very close attention to the interest rates within the terms and conditions. These could change on a daily basis. If you find you have trouble interpreting the ‘fine print,’ ask all the questions you need. This is a big decision and you have the right to be informed.
- Pay any and all fees up front. This shows the initiative to pay the loan back in a timely manner.
- Keep your own copies of bank records, checks are written, receipts for the loan, etc. People make mistakes and having an accurate back-up could save you a lot of money.
- There is something called ‘the three Cs’ that lenders tend to observe when deciding on approving a loan application or not: character, capacity and credit. Your character is just who you generally are. Your capacity is essentially an estimated measurement of how much you can afford to spend. Your credit? Well, you should by now know that it’s the key to a good loan. How efficiently do you pay lenders back? It’s usually most of what they care about when it comes to loan approval.
- Only take out a loan if you really need it. Seriously. Review this in your head, with your loved ones, with friends, with advisors if necessary. This is a major life decision that if mishandled, could cause severe financial stress. However, if handled responsibly, a personal loan is arguably the best thing for a credit score.
There are three major credit bureaus in the United States. Equifax, Experian, and TransUnion all compete with one another to provide credit scores for individual consumers. This is why you have three credit scores. Well… you actually have four. FICO, which stands for Fair Isaac Corporation, is generally used by all three credit bureaus as part of determining your credit score. In the case of granting personal loans, lenders tend to view one’s FICO score with much more weight than any of the other three scores. In fact, according to FICO themselves, “FICO Scores have been in use for over 25 years, and they are used by 90% of top lenders.”
Still, each of the three main credit bureaus offers reliable information. And although FICO scores are most often observed, lenders also pay attention to other scores, sometimes even beyond the four we’ve talked about.
If you don’t have a credit score of 650-660 or higher, considered good or better from there, and you truly need a personal loan, fear not. There are plenty of fair personal loan options available for those with low credit scores. Yes, it’s unlikely you’ll land that locked-in low-interest deal with fees waived – but plenty of Americans are in the bad credit boat, and waters have become much more navigable.
The vast majority of personal loan interest rates are lower than credit card interest rates, regardless of credit history. There are countless reasons for people to take out a personal loan, but again, credit card debt consolidation is often cured by a responsibly handled personal loan. Your life story can go a long way in a one-on-one with a loan officer, as well. Plenty of financially responsible people acquire bad credit scores for various reasons.
In the end, remember to do your research when shopping for lenders, but to also be wary of credit inquiries all the while. Building credit and securing loans can be a bit of tricky terrain, but once you know the lay of the land, financial security can indeed be a signature away.
Chris Fuller went to the University of South Florida and has worked in the financial sector for over 20 years. He has extensive experience in all aspects of personal and small business lending, from personal loans, equipment finance to cash flow based solutions for small mom and pop businesses, and large corporations.