Personal loans are a popular form of borrowing that can be used for a variety of purposes, such as paying off credit card debt, making home improvements, or financing a big purchase. But how does taking out a personal loan affect your credit score? Here's what you need to know.
How do credit scores work?
Before we can delve into how personal loans affect your credit score, it's important to understand how credit scores work. Credit scores are three-digit numbers that are used to evaluate your creditworthiness. They are based on information from your credit reports, which detail your credit history, including your borrowing and repayment habits.
The most commonly used credit score is the FICO score, which ranges from 300 to 850. A higher credit score indicates that you are at a lower credit risk and may be more likely to be approved for loans and credit cards.
How do personal loans affect your credit score?
Taking out a personal loan can have a small impact on your credit score. Here's how:
Credit inquiries: When you apply for a personal loan, the lender will typically do a "hard inquiry" on your credit reports. This type of inquiry can have a small, temporary negative impact on your credit score, as it may indicate to lenders that you are seeking additional credit.
Credit utilization: Your credit utilization ratio is a measure of how much of your available credit you are using. It is calculated by dividing your total credit card balances by your total credit limits. A high credit utilization ratio can have a negative impact on your credit score, as it may indicate to lenders that you are relying too heavily on credit. Taking out a personal loan may increase your credit utilization ratio, particularly if you use the loan to pay off credit card debt.
Payment history: Making on-time payments on your personal loan can have a positive impact on your credit score, as it shows lenders that you are responsible for your credit. Late or missed payments, on the other hand, can have a negative impact on your credit score.
Factors that may affect the impact of a personal loan on your credit score
There are a few factors that can affect the impact of a personal loan on your credit score:
Credit score at the time of application: If you have a high credit score when you apply for a personal loan, the impact of the loan on your credit score may be smaller than if you had a lower credit score.
Loan amount: The amount you borrow can also affect the impact of a personal loan on your credit score. If you borrow a larger amount, it may have a bigger impact on your credit utilization ratio and may therefore have a greater impact on your credit score.
Payment history: As mentioned above, making on-time payments on your personal loan can have a positive impact on your credit score, while late or missed payments can have a negative impact.
Other ways personal loans can affect your credit
In addition to the impact on your credit score, personal loans can also affect your credit in other ways:
Credit mix: The types of credit you have can affect your credit score. A diverse combination of credit types, such as credit cards, personal loans, and mortgages, can positively impact your credit score.
Debt-to-income ratio: Your debt-to-income ratio is a measure of how much of your income goes towards debt payments. A high debt-to-income ratio can have a negative impact on your credit score, as it may indicate to lenders that you are overextended financially. Taking out a personal loan may increase your debt-to-income ratio, particularly if you have a high balance on your loan relative to your income. It is important to carefully consider your debt-to-income ratio before taking out a personal loan, as having a high ratio may make it difficult to obtain credit in the future.
Length of credit history: The length of your credit history can also affect your credit score. If you have a longer credit history, you may have a higher credit score due to your demonstrated ability to responsibly handle credit over time. Taking out a personal loan may shorten the length of your credit history if you have not had credit for a long time, which could potentially have a negative impact on your credit score.
Conclusion
Personal loans can have a small impact on your credit score, depending on various factors such as your credit utilization ratio, payment history, credit mix, debt-to-income ratio, and length of credit history. It is essential to carefully consider these factors before taking out a personal loan and to use credit responsibly to maintain a good credit score.