Do Personal Loans Affect Credit Scores?
Posted by Frank Gogol in Loans | Updated on May 30, 2023
Unsecured personal loans can be a fast way to handle unexpected expenses. However, one major issue you need to understand is do personal loans affect credit score. Read on to learn about the positive and negative effects of personal loans and make an informed decision.
Table of Contents
What Is a Personal Loan?
Most personal loans are unsecured. That means you do not have to provide any collateral for the lender. Instead of collateral, the lender relies on other information about you to predict how likely you are to pay the loan back. Most commonly, this information is your credit score.
Unlike a mortgage or auto loan, you can spend a personal loan on whatever you decide. There are many reasons people decide to get personal loans such as:
- Emergency home or auto repairs
- Medical emergencies
- Starting a small business
- Refinancing other, higher-interest debt (e.g. credit card debt).
Advantages of a Personal Loan
Although personal loans tend to attract higher interest rates than secured loans such as mortgages and auto loans, they have some significant advantages.
- Interest rate: The interest rate of many personal loans is significantly lower than credit card interest rates. Many lenders offer personal loans with between 10% and 15% interest, whereas credit card interest rates can even exceed 30%.
- Control: Once you receive your loan, you can spend it on whatever you decide. Unlike a mortgage or auto loan, you are not restricted in how you spend the money. Most people use personal loans to fund financially burdensome emergency expenses or start small businesses.
- Unsecured: If you do not repay a personal loan, none of your belongings will be seized by the lender, but your credit score will decrease. That makes it much more difficult (or expensive) to get loans in the future. However, you do not need to provide any valuable collateral to get the loan.
- Paperwork: The lack of collateral and modest size of many personal loans means there is usually little documentation required to get one. In the last several years, there has been an increase in the number of online lenders who do not even require face-to-face interaction to grant personal loans.
Factors that Impact Your Credit Score
Different credit bureaus have different ways of using information about people to create a credit score, which they then sell to lenders. Most often, this score takes various factors into account, including:
- History: Your history has the greatest ability to affect your score. It refers to whether you tend to make debt payments on time. Missing a payment on your loans decreases your credit score.
- Current debt: This refers to the current debt ‘burden’ you have. Lenders are more comfortable lending you money if you have well below the amount of debt you could have. This is because there is a lower chance that you could become overextended, and potentially start missing payments.
- Length of history: Having credit lines open, or showing responsible use for a long time shows a consistent pattern that lenders trust to predict your future behavior. Keeping up payments on a long-term loan (e.g. mortgage) boosts your credit score.
- New debt: If you have recently applied for a lot of new loans or lines of credit, lenders take this as an indicator that you are in financial distress, and are more reluctant to lend.
- Types of debt: Having a diverse mix of types of debt that you handle responsibly (e.g., car loan, credit card, mortgage) can boost your credit score.
Once you understand a bit more about your credit score and how it’s calculated, you are in a better position to understand do personal loans affect credit score.
How Personal Loans Help Your Credit Score
When considering how do personal loans affect credit score, keep in mind that the effect can also be positive. Listed below are several ways in which getting a personal loan can help your credit score:
- Diversity: Different types of credit count towards your credit score. They fall into different categories such as installment loans (monthly payments against a single lump sum balance) and revolving loans (payment against a facility that ‘resets’ and is continuously available). Personal loans are installment loans and credit cards are revolving. Having a good balance of different types of loans that you never miss payments on helps to boost your overall credit score.
- Pattern: The main goal of a credit score is to give lenders an idea of how you have previously used credit, and therefore help them predict how you will use the loans they give you in the future. Having a history of on-time personal loan payments helps boost your credit score by showing that you are capable of handling a loan over a long period.
- Utilization: One factor that is used to calculate your credit score is the credit utilization ratio. This is the percentage of all the revolving credit (e.g. credit card) facilities you have available that you are using. Having a low utilization ratio increases your credit score. If you have an emergency, a personal loan can help you cover it without using a credit card, which would increase your credit utilization ratio and hence slightly decrease your credit score. This effect is quite small, however, and goes away as soon as you repay the balance on your revolving (credit card) loan facility.
How Personal Loans Hurt Your Credit Score
As helpful as they can be, personal loans can also damage your credit score if you do not handle them correctly.
- Inquiry: Before granting your application, lenders contact the credit bureau to check your score and credit history. There are two types of checks: hard and soft inquiries. Soft credit checks (used for prequalification) do not affect your score. Hard checks do, and the effect lasts for several months. If you want to compare offers from many different lenders, it is best to do so within a week or two. The bureau interprets this as rate shopping so it limits the impact of each hard inquiry on your score.
- Fees: Although they are quite simple to apply for, it is still important to fully understand the loan agreement for a personal loan, especially concerning fees. These include fees for late payments, early termination, administration, and other fees. Make sure you understand what all these fees are and whether the loan will work for your needs.
- Payments: The biggest negative effect a personal loan has on your score is if you miss a payment or pay less than the minimum amount.
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The answer to do personal loans affect credit scores is yes. The effect can be either positive or negative depending on how you handle the loans. The application process requires a hard credit check which can temporarily decrease your score, but making on-time payments over the life of the loans will increase your credit score overall. It is important to also be aware of fees other than the interest and to make sure you never miss a payment.