How Does Personal Loans Affect Your Credit Score? – Forbes advisor
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Getting a personal loan can be a great way to achieve two goals at once: borrow money for a big purchase you need to make and build your credit score. This can help you in the future when you want to open a rewards credit card or borrow more money, such as a mortgage to buy a house.
One of the weird things about using personal loans to build credit is that it affects your creditworthiness in many ways, for better or for worse. If you make all payments on time, the net impact is usually positive. Still, it’s helpful to know how personal loans affect creditworthiness so that you aren’t surprised if your score goes a different direction than you intended.
Factors That Determine Your Credit Score
Your credit score is based on the following factors, according to FICO, the most popular credit scoring company:
- Payment history – 35%
- Amounts owed – 30%
- Loan History Length – 15%
- Credit mix – 10%
- New loan – 10%
Your personal loan will affect each of these factors in different ways and at different times. Let’s see how they work over the course of a personal loan life cycle.
Shopping for a personal loan
For the most part, finding a personal loan will not affect your credit score. That’s because most lenders soft credit when they submit your information to see what interest rate you qualify for. This won’t be recorded as an official request on your credit report – it won’t happen until the next step.
When checking your interest rate before applying for a loan, it is always a good idea to make sure that the lender is completing a soft loan application rather than a hard query. Otherwise, you could be wrongly docked to a few points on your creditworthiness if they do a tough credit check instead.
Applying for a personal loan
Applying for a personal loan can cause a five point drop in creditworthiness for most people. That’s because when you’re ready to apply for the loan, the lender will do a more detailed credit check known as a hard credit pull. This will actually be recorded as a credit inquiry on your credit report, and since buying credit is a somewhat risky activity, your credit score will typically drop a few points accordingly.
The good news is that these loan inquiries are short-lived. After a year they will no longer negatively affect your credit score, and after two years they will be completely off your credit report.
Paying back your personal loan
You will most likely see the biggest boost in your credit score if you make your payments on time each month. Payment history is the number one determinant of your credit score, and every month you record a payment on time, your credit score may slowly improve.
On the flip side, this is the period when you are also most at risk of harming your creditworthiness. Making a late payment can drop your score, but how far it drops depends on a few factors:
- Time overdue. Payments are reported 30 days late and the later the payment, the worse the impact on your score.
- Overdue. The more you are overdue with payments, the more negative the impact on your score.
- Frequency. The more often you make late payments, the worse it will affect your score. If all you have is one late payment, the effect might not be that bad.
Over time, these late payments won’t keep your score quite that low, especially if you make the rest of your payments on time. Late payments will expire on your credit report after seven years.
Why does repaying a loan hurt the credit?
A smaller part of your credit score is made up of your credit mix – what types of credit you have, such as credit cards, mortgages, student loans, and personal loans. Taking out a personal loan diversifies your credit mix, which helps your score. On the flip side, repaying your personal loan will decrease your credit mix, especially if it’s the only type of installment loan you have.
Because of this, paying back your personal loan can sometimes affect your credit score. Even so, it’s good to be debt free.
When you have a lot of unsecured debts, such as credit cards or other personal loans, it can sometimes make sense to consolidate them by taking out a larger personal loan to pay off all of those other debts. This gives you a number of advantages:
- You only make one payment instead of many
- Maybe you can get a better interest rate
- You may be able to improve your credit score
Diversify your credit mix
Consolidating your debt helps your credit score in two ways. First, if you don’t already have a personal loan, you can potentially diversify your credit mix. As long as you can manage it well, lenders want to see you can deal with multiple types of debt and you will be rewarded with better credit for doing so.
Lower your loan utilization rate
When you have credit card debt, an even greater benefit to consolidating your debt is that you can lower your credit load. This is the ratio between your debt level and the amount of your credit limit combined across all of your credit cards. The reason for this is that the closer you are to your cards’ exhaustion, the riskier you are, and your credit score will dock accordingly.
By converting this debt from your credit card balance to a personal loan, you are suddenly freeing up your credit card balance so it looks like you are only using a tiny fraction of your available credit. This makes you appear more trustworthy to lenders and your credit score can go up as a result.
Of course, for this strategy to work you must keep also these credit card balances. Just because you now have a lot of credit available doesn’t mean it is a good idea to top up with a large amount of credit. If you do, you will be back to where you started – but with more personal loan debt.
Watching how your personal loans affect your credit score is a bit of a roller coaster ride. Your score will go up and down throughout the process, but for most people, if you make all of your payments on time, you will end up with a higher credit score than when you started. Because of this, it’s an especially good idea to auto-pay your personal loan payments so that your creditworthiness automatically improves over time.