Taking out a personal loan is often necessary to help cover large expenses or consolidate high-interest debt. However, the impact a personal loan can have on your credit score is an important factor to consider. Your credit score plays a crucial role in your ability to access credit and the interest rates you will pay.
In this blog post, we will discuss how a personal loan affects your credit score and the steps you can take to minimize any negative effects.
Pros and Cons of Availing a Personal Loan:
Here are some of the pros and cons that taking out a personal loan affects credit score:
Pros:
1. Better Credit Mix
Having both loans and credit cards in your credit portfolio demonstrates to lending companies that you can responsibly manage different types of credit. This diversity of credit types can improve your credit score, as credit scoring models like to see you handle and be responsible with credit.
2. On-Time Payments
Making consistent and timely payments every month over the entire repayment period of the personal loan builds a strong positive payment history. Payment history is the most important factor in your credit score. A good payment history on a personal loan can significantly improve this major component of your score.
3. Better Credit Utilization
Using funds from a personal loan to consolidate and pay off high credit card balances may lower your overall revolving credit utilization ratio. Lower credit card balances compared to limits can improve your utilization metric and help improve your credit score. This depends on the overall impact on your total debt.
Cons:
1. Hard Credit Inquiries
Every application for a new credit account triggers a hard inquiry on your credit report, including personal loan applications. These inquiries can affect your credit score slightly, usually between 2-5 points per inquiry. Too many inquiries in a short period of time can indicate a higher risk to loan providers.
2. Increased Overall Debt
Taking out a new personal loan increases your total outstanding debt across all accounts. Loan providers view higher total debt as a risk factor, and it can negatively affect your credit score.
3. Missed Payments
Failure to make payments on time on the new personal loan can severely damage your credit profile. Payment history is the single biggest factor that affects your credit score. Even one missed payment can lower a great score.
Steps to Minimize Credit Score Damage
While qualifying for a personal loan will require a credit check and will impact your score to some degree, there are steps you can take to minimize the potential downside:
- Only Apply for Affordable Loan Amounts: Applying for a loan you can’t comfortably handle could negatively impact your credit utilization and ability to make timely payments. Know your budget and stay within your means.
- Maintain Low Credit Utilization Going Forward: After you take out the loan, keep balances on credit cards and other revolving accounts low to neutralize the impact of the new loan on your overall utilization.
- Make All Payments on Time: Payment history is the biggest factor in your credit score. Be sure to always make at least the minimum payment on your credit card and preferably pay more than the minimum whenever possible. Set up autopay or payment reminders to avoid missed payments.
- Limit Credit Applications: Each credit application can hurt your credit, so avoid applying for multiple loans within a short timeframe. Compare rates and terms and apply with a loan provider most likely to approve your loan.
The Bottom Line
Taking a personal loan to finance your individual needs can significantly affect your credit score. While the impact can be both positive and negative, your responsible credit behavior can ensure that it is only positive.
