How Do Personal Loans Impact Your Credit Score?

May 4, 2022

4

min read

P

ersonal loans are like a fire; if handled well, they can give you warmth, but they can also burn your house if you mishandle them. Likewise, personal loans can improve and hurt your credit score depending on how you use them.

Since personal loans are debt, acquiring them may temporarily lower your credit score, which would be the additional debt on your financial profile. However, paying the debts on time will help you boost your credit history and profile.

Furthermore, personal loans are lifesavers when you need to borrow loans for life events such as marriage, vacations, home renovations, or funeral expenses.

But, before taking out these loans, one should know what impact these loans have on your credit score.

Factors Affecting Credit Scores

Before moving to how personal loans affect credit scores, it is essential to know what factors affect the credit score.

The most widely used credit score is FICO which ranges between 300 and 850. These scores are calculated based on the five factors, which are as follows:

Credit Score Elements — **https://www.freepik.com/vectors/money-card**

Payment history: How timely do you pay your interest and principals?
The total amount of your outstanding debt: What is your total debt?
Length of your credit history: How long are your credit accounts open and active?
Recent application: Any new debt or newly opened lines of credit?
Credit mix: How diverse are your loans?

Click here to know more about the factors affecting credit scores in detail.

How Does A Personal Loan Affect Credit scores?

Borrowing a personal loan adds new debt to your credit profile, affecting your credit rating. However, the credit agencies consider more than the number of obligations while determining the credit score.

Here's how personal loans positively and negatively affect the credit score:

Hard Inquiries

Your credit score influences your personal loan before it affects your credit score. Your personal loan is easily approved if you have a good credit score, whereas poor credit scores might reject your loan.

When you apply for a personal loan, you will be subjected to a credit check. A hard credit check happens when you authorize a firm, such as a personal loan lender, to examine your credit.

Hard checks significantly impact your credit scores as the hard inquiries stay in the credit profile for two years, affecting your overall credit score.

Repayment History

The credit bureaus consider the payment history seriously while calculating the credit scores. It's not about how much you owe but how timely you pay your debt.

Paying debt is an obligation and paying debt on time shows how liable and reliable you are for the debt.

The payment history alone accounts for 35 % of your credit score, and if you pay off your personal debt on time, then there is a high chance that your personal loan could boost your credit score.

Meanwhile, if you fail to pay your loan on time, it can negatively impact your score.

Diversified Loan Portfolio

When you take out a personal loan, you boost your credit mix, which accounts for around 10% of your credit score.

While expanding your credit mix is beneficial, it also increases the amount of debt you owe, which might lower your credit score.

Most people take out personal loans for the diversity in their loan profile and show how effectively they can manage them.

Taking out a personal loan to improve your credit isn't always a bad thing if you can afford it. If you cannot afford it, you may default on the loan, significantly damaging your credit score.

Total Debt

The personal loan might diversify your loan portfolio, but it adds up your total debt. Having several debts hampers your credit score and credit history.

Having more liabilities indicates that you are financially risky and have a high chance of defaulting on the loan. Thus, it decreases your creditworthiness and lowers your credit score.

So, if you already have high total debt, it is not advisable to borrow a personal loan as it can significantly impact your credit score.

On the other hand, if you have low total debt, you can borrow a personal loan to diversify your loan portfolio and thus, increase your credit score.

Conclusion

Thus, personal loans have a significant impact on the credit scores based on how it is used.

Personal loans can be a great way to improve your credit scores through debt consolidation and on-time payments, whereas it can hamper your credit scores if you are taking too much debt and are ignorant of paying the loans on time.

The credit scores can see a slight drop while applying for the credit scores due to the hard inquiry done by the lenders before approving the personal loan. But, if you can manage personal loans effectively, it helps to build a good credit history in the long term.