Do Personal Loans Affect Your Credit Score?

How Personal Loans Impact Your Credit Score?

Applying for a personal loan is common to meet emergency needs or to combine several loans. However, there may be some questions that borrowers, who decide to apply for a personal loan, can have about their credit scores. In short, personal loans do impact credit score and the impact may be either positive or negative depending on how the personal loan is managed. Continue reading to gain more insight on how personal loans impact credit scores.

How do Personal Loans Affect Credit Scores?

Lenders report newly opened personal loan accounts to the three credit reference agencies including Experian, Equifax, and TransUnion. This immediately affects two important factors in the credit score calculation: The credit mix and length of credit history are two factors that affect the credit score. New credit, such as a newly opened credit account, reduces the average length of credit that has been established, at least in the beginning. Over time as the loan ages, this factor is less of a concern since the borrower has already incurred the cost.

Furthermore, there is up to 10 percent of a credit score that is determined by credit mix. This is regarding having credit cards as well as other forms of loans and credit accounts. Thus, getting an installment loan such as a personal loan will enhance credit mix and ratings.

Of course, how you manage the personal loan also greatly impacts your credit score.

On-Time Payments: This is because you can avoid late fees as well as damages to your credit rating in case of delayed monthly payments. Credit score accounts for the largest component at 35 percent which is payment history. Late payments as little as one 30-day late payment can reduce scores by over 100 points.
Credit Utilization: One can easily understand that using most of the loan’s credit limits lowers the scores since high utilization means high risk. Some benchmarks indicate that the rate of utilization must be below 30 percent. It is observed that the impact is maximum in the initial month of taking the loan out.
Interest Rates: Even though the credit scores do not factor in interest rates directly, higher interest rates mean that the lenders may consider you as a high risk if you have bad credit. Erase balances and you can be in a better position to get new loans or own loans with better interest rates.
Length of Credit History: Keeping the loans open and active for their entire tenure is also helpful for the credit history as it extends the life of that credit line moderately affecting scores. Surprisingly, it is even beneficial to close old accounts that have been repaid and which are adversely affecting scores.
Hard Inquiries: Each time you apply for new credit, it leads to a hard inquiry on your credit report. Requesting credit reports too frequently may also lower your score by a few points for some time.

How do personal loans impact your credit score?

Overall, individuals should brace themselves for a slight decline in credit scores when they apply for a personal loan: below 20 points for those with good credit (690 and above). People with scores below 620 could have their scores reduced between 20 to 60 points. However, if the loan is handled well than usual, the scores normally rise back in a few months only. They may then further improve over the loan repayment period.

However, getting over the 30-day mark or missing payments can decrease the scores by 100 points or more. Large payment arrears, charges, or sometimes even business failures can do an even worse job.

Here are a few examples of potential score impacts.

A borrower with very good credit standing avails a new personal loan product for $15,000. Their score decreased by 12 points to 768 after the SOAR, hard inquiry, and account mix impact.

An individual with fair credit (680 credit rating) borrows $10,000 and secures the money with a personal unsecured loan. They lose 6 points to the hard inquiry, but no points are lost to the soft inquiries. Taking off another 9 points is the higher credit utilization. So their new score is 665.

A borrower with a poor credit rating of 550 takes an unprotected unsecured personal loan of $5,000 at an APR of 29. 99 percent. The hard inquiry reduces their score by five points. High interest rates mean high risk so another ten points are deducted. A new score could be somewhere around 535 as per their current level of understanding.

Of course, the consequences are much larger for borrowers with bad credit at the start. However, they can regain their account scores responsibly and hence improve their account scores over some time.

Strategies to Avoid Credit Score Deterioration when Using Personal Loans

Here are some tips to avoid hits to your credit from taking out a personal loan.

Shop for rates carefully. To limit the impact of the multiple hard inquiries, their use should be limited to not more than two weeks to ensure they are counted as one inquiry.
Seek to obtain loans with interest rates below 10 percent, a sign of lower credit risk to the moneylenders. This is whereby, high interest rate hits to scores are prevented.
You could also approach a co-signer with a better credit score to improve your chances of getting a better deal on the loan.
Ensure that the amount borrowed from the personal loan does not exceed 30 % of the total credit line.
Maintain a convenient payment schedule by opting for autopay.
Reduce credit card balances while paying off the personal loan to better credit utilization.
It is recommended not to apply for and open any credit while repaying the personal loan balance.
Check your credit record from time to time for such items as late payments that could have been reported incorrectly.

Final Takeaway

Using a personal loan responsibly is a way of enhancing credit mix, length of credit history, and payment experience. Just don’t overdo it with the hard inquiries when rate shopping, keep your credit utilization low and always pay your bills on time every month. This means that when you have taken a loan, you should limit your credit application to repay the loan in the agreed time. It is advisable to adhere to the following best practices to fully benefit from personal loans in terms of credit rating.

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