You’re facing a mountain of credit card debt with sky-high interest rates and don’t know where to start. Your hot water heater broke and needs to be replaced, but you don’t have the money saved to pay for it. Or perhaps you have a job offer in another state, and you need cash to finance the move. Whatever the circumstances, taking out a personal loan can be a smart way to handle major expenses or consolidate debt.
A personal loan is a form of unsecured debt that you can use for many different expenses, that doesn’t require any form of collateral. Instead, lenders base the loan terms on your creditworthiness, including your credit score and income.
But how do personal loans affect credit scores? Depending on your finances and how you handle the loan, a personal loan could have a positive or negative impact on your score.
3 ways a personal loan can boost your credit score
With a personal loan, you can get the money you need within just a few days, helping you tackle any emergencies that arise. You can often apply for a personal loan online and get approved within minutes, making it an easy form of credit. And, if you’re thinking of taking a personal loan out, applying for one can actually raise your score in the following ways:
1. You can establish a positive payment history
According to myFICO, the organization behind the FICO credit score, your payment history determines 35% of your credit score. Keeping your accounts in good standing shows lenders that you’re a responsible borrower.
When you take out a personal loan and make all of your payments on time, you improve your payment history. Over time, keeping up with your payments can increase your credit score. Keep in mind that if you pay off your personal loan early, you’ll lose out on the payment history benefits, since you won’t have as many on-time monthly payments as you would with the full loan term.
To ensure you get the full benefit to your credit score, sign up for automatic payments to reduce the risk of forgetting a due date.
2. You improve your credit mix
Lenders like to see that you can handle multiple types of debt, including credit cards, installment loans, car loans, or mortgage loans. Your credit mix — the different types of credit under your name — accounts for 10% of your credit score.
If you only have credit card debt or student loan debt, taking out a personal loan can be one way to improve your credit mix. Diversifying your credit mix can result in a modest increase in your credit score.
3. You can lower your credit utilization
If you’re carrying a balance on a credit card, you may signal to lenders that you’re overextended. Your credit utilization — how much of your available credit you use — makes up 30% of your credit score.
When you consolidate credit card debt with a personal loan, you pay off the card balances, freeing up your credit lines on those cards. Consolidating your debt can improve your credit utilization and increase your credit score. In fact, you can see a significant improvement in your score within a few days of paying off your card balances.
3 ways a personal loan can lower your credit score
While a personal loan can be useful, it’s important to consider both the pros and cons of applying for a loan. There are three potential drawbacks you should know about:
1. Credit inquiries can lower your score
When you apply for a personal loan, the lender will run a hard credit inquiry when they review your application. Hard inquiries can lower your credit score. According to myFICO, most people will see their credit scores decrease by up to five points per hard credit inquiry.
To minimize the impact on your credit score, look for lenders that offer rate quotes with just a soft credit check. Soft credit inquiries don’t affect your credit, so you can see potential interest rates without submitting a full application. Once you find a lender that offers competitive rates and terms, you can move forward with their application process.
2. Late payments wreck your payment history
Your payment history is the single biggest factor in determining your credit score. If you take out a personal loan and miss a payment, you could significantly damage your credit.
According to Equifax — one of the three major credit reporting bureaus — a 30-day delinquency could cause your score to drop by as much as 110 points. If your credit score was 780 — a score in the “very good range” — your score would drop to 670, putting you in just the ‘good” range. If you were to apply for a credit card or loan after your score dropped, you may struggle to get approved or be subject to higher interest rates than you would’ve gotten with a better credit score.
3. Having new credit affects your score
New credit determines 10% of your credit score. Fresh accounts can make lenders nervous because they may think you’re taking on too much new debt and will struggle to keep up with the payments. If you don’t have a lengthy credit history, taking out a personal loan can cause your score to drop. If you’re thinking about applying for a personal loan, limit how often you apply for new forms of credit.
Alternatives to personal loans
Although personal loans can be a good financing option, they’re not for everyone. Instead, consider these alternatives to consolidate debt or to cover an unexpected expense:
1. Complete a balance transfer
If you have high-interest credit card debt and are considering taking out a debt consolidation loan, another option is to complete a balance transfer to a card offering an introductory APR period. Some cards offer a 0% APR for up to 18 months, giving you a year and a half to pay down your balance without paying interest fees. If you can pay off the balance before the promotional period expires, you can save a significant amount of money; it could even be cheaper than a debt consolidation loan.
2. Use an existing credit card
Rather than taking out a new loan, you could use an existing credit card to pay for a major purchase, like a new appliance. This approach is a smart choice if you think you can pay off the balance in a month or two, and just need a little help with the upfront cost. You can use the credit card to pay for it right away, and skip having to go through the process of applying for a loan and making years of payments.
3. Request a paycheck advance
If you are facing an unexpected car repair or other emergency, ask your employer for an advance on your paycheck. Unlike loans, paycheck advances don’t have to be repaid, and you don’t have to pay interest fees; you’re simply getting a portion of your pay earlier than scheduled.
4. Ask for help
If you have a minor emergency and need money quickly, think about asking friends or family members for help before applying for a loan. It may be embarrassing to admit you need help, but a loan from a loved one will be cheaper and easier to manage than a personal loan, and it won’t affect your credit score.
Responsible borrowing best practices
If you decide that taking out a personal loan is right for you, make sure you follow responsible borrowing practices. Here are four tips for managing a personal loan:
1. Borrow the minimum needed
Personal loan lenders make it easy to borrow money. Depending on the lender and your credit, you could borrow up to $100,000, and have the money deposited into your account in as little as one business day.
While it may be tempting to borrow more than you strictly need to give yourself some wiggle room, resist that urge. The more you borrow, the more you’ll pay back in interest, and higher amounts mean you’re more likely to fall behind on payments. Instead, borrow the absolute minimum you need to pay for your purchase or consolidate debt.
Of course, make sure you only borrow money if it’s absolutely necessary. Financing a purchase you can’t afford is one of the worst reasons to take out a loan.
2. Make sure you can afford your payments
When thinking about how large of a loan to take on, make sure you can comfortably afford your payments with your current monthly budget.
You can use a personal loan calculator and enter your desired loan amount, term, and interest rate to find out what your monthly payment will be. Not only will the calculator tell you what your payment will be, it will also tell you how much you’ll pay back in interest over the length of your loan.
3 Comparison shop
It’s a good idea to compare offers from several personal loan lenders to ensure you get the best deal. Requirements, loan terms, and interest rates vary from lender to lender, so you may be able to get a better deal by looking at different lenders.
Using a personal loan
If you have high-interest credit card debt and are looking to accelerate your repayment, or if you have an expensive repair to pay for, a personal loan can help you achieve your goals. However, taking out a loan can affect your credit score, so it’s important to weigh the pros and cons to make an informed decision. Everyone’s circumstances are different, so deciding whether or not to take out a loan is a decision you have to make for yourself.