With so many financial tools and support at our disposal, we need to understand exactly how they can boost our financial status and not hurt it. Personal loans carry many benefits and risks that are important to know before applying, especially how it impacts your credit score. Read further to find out how you can prevent your credit score from being negatively affected by a personal loan.
Firstly, what are a personal loan and a credit score?
Personal loans are loans that can be used for any general purpose, unlike home or car loans. For example, needing capital to start a business or to pay for urgent home repairs. Unsecured personal loans often have lower interest rates than credit cards, but higher in comparison to secured personal loans taken out against collateral. Your loan agreements, term, and approval are dependent on your credit score, how much money you need to borrow, and payment history, amongst other factors. A good credit score is key to get approved quickly and with good loan terms and interest rates.
Your credit score is a three-digit number that is an indication of your creditworthiness, based on your credit report put together by lenders. Credit scores can range from 300-579: poor, 580-669: fair, 670-739: good, 740-799: very good, and 800-850: excellent. The higher your credit score, the lower risk you are to lenders as opposed to low credit scores with more risk. This means you will be able to benefit from lower interest rates.
What makes up a credit score?
A credit score is calculated by your previous payment history (if you are on time with making repayments), how much debt you currently have, the length of your credit history, credit utilization ratio, credit mix, and your account or enquiry activity. These factors determine how high or low your score is.
This is how having a personal loan can affect your credit score; keeping up with payments, the amount of existing debt, and making enquiries when applying. Applying for a loan is a hard enquiry. This means that the lender will review your credit report from credit bureaus to assess your application. This enquiry shows up on your credit report and affects your credit score for some time.
How a personal loan can help your score
Taking out a personal loan and being responsible with payments can help build a good credit score in the long term. Your credit score can be positively impacted by;
Making repayments on time
This is the most important point to remember. Paying your installments consistently and in full can build a good credit history as it shows that you are financially responsible enough to make payments on time.
A better credit mix
A variety of different types of credit can help your credit score so adding a personal loan (if you have mostly revolving credit like credit cards) would be a good addition.
Reducing your credit utilization ratio
You can use a personal loan to pay off credit card debts, which can improve your credit score overall as it will lower how much debt you currently have; lowering your credit utilization ratio.
How a personal loan can hurt your score
Before you apply for a personal loan, make sure you understand how it could negatively affect your credit score:
Missed payments
Missing a monthly payment can affect your creditworthiness and significantly lower your credit score. Lenders will be able to see your payment history and if you’ve been consistent with payments.
Creates a hard inquiry
Applying for a loan issues a hard inquiry on your credit report as lenders need to assess your credit history to approve or reject your application. A hard inquiry negatively impacts your credit score, causing a dip for a few months. To apply for multiple loans to get the best terms, keep your applications within two weeks to minimize their negative impact. This will also be seen by credit scoring models as rate shopping and won’t affect your score as much.
Extra fees
Additional charges, on top of interest, can accumulate and mean paying more than what you planned. Understand what fees could be applied and what fees you can avoid.
Mismanagement
If you’re not able to manage your finances responsibly, taking out a personal loan can put you deeper into debt.
A personal loan can only hurt your credit score if you’re not adequately prepared for making payments and using it irresponsibly. To be sure that you can afford repayments, compare loans with rates best suited for you in terms of the amount owed and for how long you will need to be paying. Manage your finances and budget accordingly to avoid hurting your credit score. Understanding how your personal loan can help build your credit score, it becomes a method to improve your financial status and better your chances for a loan in the future.
