How a Personal Loan Affects Your Credit Score
A personal loan can affect your credit score in good and bad ways. Taking out a personal loan in and of itself is a good thing per se. However, this can be a problem when it comes to the short-term effects on your credit score, especially if you take out multiple personal loans. One of these adverse effects is that you won’t be able to get new credit before that personal loan is paid off entirely.
On the other hand, paying a personal loan regularly can do wonders for your credit score. This is especially true if you pay it off more frequently and above the minimum payment. We know you have many questions, so let’s delve in further.
Does Applying for a Personal Loan Affect Your Credit Score?
As mentioned before, a loan application can positively and negatively affect your credit score in the short term and long term, respectively. One negative effect is that taking out a new loan could add to your overall debt.
Also, credit bureaus will take note of this activity. Also, if you try to take out, for example, a car loan in short succession, your car loan will most likely be rejected on the basis that you already have enough debt as you can take.
Not to mention that applying for a personal loan can create a hard inquiry. Having a hard inquiry isn’t bad, but having too many for them in a short period can spell trouble for your credit score.
However, it’s not all doom and gloom. There are also benefits that you can enjoy when taking out personal loans, like improved credit mix, lower credit utilization, etc. With all that said, let’s delve in deeper.
Benefits of a Personal Loan
Taking out a personal loan can improve your credit mix, which is a factor that credit bureaus consider when calculating your credit score. Your credit mix refers to the different types of credit you have, which includes credit cards, loans, mortgages, personal cash advances, etc. While having all these accounts is optional, having a good number of them can do wonders for your credit score. This is because having different types of credit usually means you have a good sense of managing additional credits.
Personal loans can also help you establish a good payment history, which many lenders would like to see in a borrower. Payment history is also one of the factors used when calculating your credit score. Making your monthly payment regularly will tell the lender that you’re reliable with debt should you apply for a loan.
Not only that, but payment history makes up 35% of your credit score. Another thing personal loans are good for is reducing your credit utilization ratio. You might think that it has no benefits for your credit utilization since it’s a form of installment loan, but when you pay off your revolving credit with personal loans, it will be an excellent decision.
Because it’s a form of installment loan, you won’t be trapped in a cycle of paying off your credit card debt with another credit card. With this, you’ll be paying off your credit card with an installment loan, effectively reducing your credit utilization ratio,
Disadvantages of Personal Loan
Of course, since it’s a form of credit, you’ll add to your debt. Applying for it can make your credit score take a slight dip. This is because applying for credit can create a hard inquiry. Because of this, you must be wise when you take out personal loans.
For example, only apply for a new personal loan when you have paid off the previous one. Taking out a new loan while still paying off your current debt can be quite a challenge.
Doing this will make the lender think you desperately need credit, which means that you’re struggling with your finances. Not only that, but taking out multiple ones would mean that you have to pay off several origination fees or even late fees, and if you fail to pay, your credit score will take another dip.
Another thing that you should be wary of is prepayment penalties. These penalties occur when a borrower pays off the loan way ahead of the repayment terms’ maturity. When a borrower pays off the debt earlier than expected, the lender will significantly lose a lot of money because of the canceled interest payments due for the rest of the repayment terms’ duration.
Because of this, the lender will incur prepayment penalties to make up for the canceled interest payments. And as usual, if you fail to pay the prepayment penalties, it won't be good for your credit score.
Minimizing Risks
Luckily for you, there are several ways for you to minimize the risks of personal loans. Before you go ahead and take out a personal loan, here are some tips you should consider following when applying for one.
Review Your Budget - ensure you have enough room for the monthly repayments. A missed payment could shave off a few points from your credit score.
Shop Around: Not all personal loans are the same. Each lender has their prerequisites, loan terms, and interest rates. Find one that would suit you best.
Consider Setting Up AutoPay: If you’re worried about forgetting to pay your monthly repayments, you can set up an autopay in your bank account to ensure you won’t miss even a single monthly repayment.
Why Should You Take Out a Loan Anyway?
Personal loans generally allow you to borrow money at a lower interest rate than purchasing with a credit card. According to the Federal Reserve, the current average APR for a personal loan on a regular two-year repayment term is 9.58%.
On the other hand, the average interest rate of a credit card is 16.30%, at the very least, and will sometimes go as high as 24%. That said, taking out a personal loan is a much more cost-effective thing to do rather than using a credit card.
Final Words
A personal loan is useful for a variety of expenses. However, you shouldn’t take them lightly since they have disadvantages and advantages. Taking out a personal loan isn’t bad, but if you’re not smart enough about it, it could easily turn a good thing into a burden.
