How Personal Loan Debt Can Affect Your Credit Score

Taking out a personal loan will most likely lower your credit score in the short term. This is due to the fact that you are decreasing the average age of your open accounts while increasing the total amount you owe. The application will also temporarily lower your score.
However, the benefits of taking out a personal loan for financial milestones such as debt consolidation, home remodeling, or emergency expenses frequently outweigh the short-term risk.

What factors influence your credit score?

Payment history, amounts owed, length of credit history, new credit, and credit mix are the five main components of a FICO credit score. FICO calculates your score based on these factors.
Lenders do not use FICO as the only credit score. Another one is VantageScore, which is composed of six factors: payment history, credit age and mix, utilization, new credit, balance, and available credit.

What effect an open personal loan has on your credit

Debt from any type of loan can have a negative impact on your financial health if it is not properly managed, and an open personal loan is no exception. However, a personal loan that is paid on time and managed properly can be beneficial to your credit.

Positive outcomes

A personal loan can help you improve your credit in a variety of ways.
Payments are made on time. Your ability to pay on time accounts for 35% of your FICO and 41% of your VantageScore, the largest portion of both. Assuming you consistently pay on time, your credit score may improve.
Credit allocation. Your credit mix, or the diversity of your accounts, accounts for 10% of your FICO score. If you have two credit cards, for example, a personal loan will broaden your credit mix and provide you with options other than revolving accounts.

Negative consequences

Consider how a personal loan can harm your credit score before taking one out.
Payments were not made on time. When it comes to borrowing, paying your personal loan on time and in full is critical. It accounts for the majority of your FICO and VantageScore credit scores.

The amount owed. As the amount owed on your personal loan increases — which accounts for 30% of your FICO credit score — you may notice a slight drop in your score. FICO considers amounts in a variety of contexts, including the total amount owed. It also compares revolving accounts, such as credit cards, to installment accounts, such as personal loans.
An in-depth investigation. Lenders will run a hard credit pull whenever you apply for a loan. This temporarily lowers your score. If you don’t have too many inquiries, this will be resolved quickly.

How your credit score affects your overall financial well-being

Your credit score is an indicator of your financial standing. The number categorizes you and informs lenders about your potential risk.
However, even if you are not looking for a loan, this number is important. In some states, insurers, employers, and landlords can use your credit to determine your dependability. A credit score in the 300 to 579 range, considered poor by FICO, may prevent you from getting approved for your dream home or extending your credit line to buy a big-ticket item.
Your three-digit credit score influences your eligibility for personal loans, as well as credit cards, mortgages, car loans, and noncredit products. A strong credit history, in its most basic form, will help you earn lower interest rates, more competitive terms, and serve as a positive indicator outside of just finances.
Credit checks and the weight that your credit score carries are an unavoidable reality in today’s economy, so it is prudent to work to continually improve it.

Personal loan interest rates averaged by credit score

Consider the following breakdown of average credit-based rates. As shown, the lower your credit score, the higher your interest rate. This is true for all APRs in the financial sector.

Credit score Average loan interest rate
720-850 10.73%-12.5%
690-719 13.5%-15.5%
630-689 17.8%-19.9%
300-629 28.5%-32%

How to Raise Your Credit Rating

While taking out a personal loan may result in a slight decrease in your credit score, there are some steps you can take to ensure that your credit continues to improve.

Keep track of your payments

Regardless of the scoring model used, on-time payments account for a significant portion of your overall credit score. This means that one of the most important factors in improving your credit score is paying your bills on time. Consider setting up automatic payments or setting up phone reminders so you never miss a payment.

Check your credit reports on a regular basis, as recommended by the US government, should be used every 12 months to check your credit report with each of the three major bureaus: Equifax, TransUnion, and Experian. By reviewing your score, you can identify any errors or major problems.

Reduce your credit utilization

The amount of credit you have used in comparison to the available limits is referred to as your credit utilization rate. The Consumer Financial Protection Bureau suggests that you keep this figure below 30%.
Divide your total credit card balances by total credit limits to calculate your credit utilization rate. The smaller the number, the better. Keeping your credit utilization rate low by paying off your credit card balances in full each month.

In conclusion

While taking out any type of loan involves some financial risk, don’t let that deter you from obtaining a personal loan to meet your needs. To ensure that you can make your monthly payments and do not owe more than you can afford, use a personal loan calculator to calculate the amount ahead of time. That way, even if you owe money on a personal loan, your credit score will be unharmed.

Related Articles

Leave a Reply

Your email address will not be published. Required fields are marked *