Many individuals are short on the money they need to pay for some of life’s most significant purchases, such as a home renovation or a major medical expenditure.
A personal loan is a type of credit that may be useful in certain circumstances.
According to an Experian study from 2020, personal loans are the most common kind of debt in the United States.
When borrowing any further money, customers should consider how their new line of credit will effect their financial life, particularly their credit score.
Personal loans can have a negative Impact on your credit score, so let’s take a look at how they work.
- When you apply for a personal loan
- How a personal loan harms your credit score.
- Get The Loan Comparison Calculator
- 3 Ways to limit Personal Loan's Negative Credit Impact
- How a Personal Loan Can Help Your Credit
- Before taking a personal loan
When you apply for a personal loan
Most consumers see a 5-point dip in their credit score after applying for a personal loan.
When you’re ready to apply for the loan, the lender performs a more hard credit check, often known as a hard credit pull.
Your lender will receive a copy of your credit report and add the inquiry to their file if you ask them to pull it.
This isn’t a totally new request, but it does show up on your credit report as a credit inquiry, lowering your score by several points.
The good news is that these credit inquiries are only temporary.
They’ll be off your credit report after a year, and they’ll have no impact on your credit score after 2 years.
Keep in mind: Lenders may provide you with an online tool that can assist you in determining your expected interest rate based on your information.
It won’t damage your score and you can be confident that you’re receiving the highest possible interest rate before submitting your application.
How a personal loan harms your credit score.
If you miss even one monthly payment on a personal loan, your credit score can take a hit.
Because payment history influences 35% of your FICO Score, a missed payment will have a much larger impact on your credit than other factors.
Even If you pay your personal loan on time, it may strain the rest of your finances and put you at greater risk of credit score damage from late payments on other accounts.
A personal loan adds to the “amounts owed” category in FICO® Score calculations, which accounts for 30% of your FICO Score.
But your credit score won’t be damaged if you simply owe money.
Although your credit score is not harmed when you’re labeled a high-risk borrower, owing money has nothing to do with it.
But keep in mind: Large bank balances and large outstanding payments on loans may cause your credit rating to be harmed.
While your debt-to-income ratio isn’t factored into credit scores, a high DTI might make it difficult to qualify for certain sorts of loans (such as mortgages), where lenders evaluate only debt-to-income ratios when making credit decisions.
So, that being said, you’re actually trying to think of how to limit the impact of this negative effect?
Here are a 3 ways to do so.
3 Ways to limit Personal Loan’s Negative Credit Impact
1. Pay off the debt in full
It’s critical not to stop making payments until the debt is paid off.
But early repayment of a personal loan will not always raise your credit score.
The account will be considered closed once the debt is paid off, and your credit score won’t benefit as much from your on-time payments history because it will no longer be open and responsibly managed.
2. Make all payments on schedule
It’s critical to pay all of your bills on time in order to keep your credit score high. This is also true of your new personal loan.
If you pay all of your personal loan payments on schedule, it will demonstrate to future lenders that you are reliable when it comes to keeping your financial obligations.
3. Apply for loans Within a 2-week frame
If you apply for a new loan within a certain time frame, your FICO score will know you’re rate shopping or comparing rates from multiple loans in the same category.
The time it takes for a lender to obtain your file from other lenders varies by the FICO Score and version.
For older FICO Score versions, 14 days is the normal, but for newer versions, it’s 45 days.
To ensure safety, submit all loan applications within the 14-day period as long as you use an older version of the FICO score.
How a Personal Loan Can Help Your Credit
Personal loans can boost your credit score in a variety of ways, depending on how you use them.
If you utilize it to improve your credit mix, you may benefit from having a variety of different forms of credit.
If your credit mix is mostly revolving credit such as credit cards, a personal loan may improve it.
You can use it to help you establish a payment history If you use it to assist you in establishing a payment history, make sure that paying your personal loan installments on time contributes to building a good credit score.
Use your personal loan to reduce your credit utilization ratio by paying down the principal amount of your loan.
Because it’s an installment loan, a personal loan does not contribute to your credit utilization ratio, which measures how much of your available revolving credit you’re using.
You may be able to raise your credit scores by replacing revolving debt (which boosts your credit utilization ratio) with an installment loan.
Before taking a personal loan
Ask yourself these 6 questions before taking the decision of taking a personal loan:
- How long will I have to make payments on it?
- Is it possible for me to cover the monthly installments?
- What other options do I have?
- How much will I be charged in interest?
- Do you have to pay any fees?
- When do I need the cash?
Personal loans are a fantastic substitute for 0% APR credit cards, but they’re most useful when used in conjunction with a strategy.
If you’ve answered all of the above questions, conduct a quick search on the lender’s website or a third-party lending market to see your alternatives without affecting your credit score.
Abdulrahman is the founder of Financeive and a financial advisor with +3 experience writing about loans and debts. He took the Nanodegree from Udacity with a degree in Business Administration and had previously finished his bachelor’s degree in Accounting as well.
He is an expert on Personal Finance who knows how to make sure that your finances will not hold anyone back anymore – even if they are struggling with paying off previous debts or just starting their life financially alone as a young adult without much income yet but lots of potential opportunities ahead.
He used to help Individuals and Small Businesses to get loans with low interest and has figured out ways to help most of them to get out of loans Debt.