There comes a time in most of our lives when we may need a personal loan. But taking on debt isn’t necessarily a bad thing. You may need to borrow money for one of life’s milestones, such as to afford the cost of college or to pay for your wedding.
Personal loans can be used for a variety of purposes, but they can also affect your financial health. Before taking out a personal loan, you may want to consider how this loan will affect your credit. As well as how you can borrow responsibly.
What comprises a credit score
There is a common financial misconception that you only have one credit score. In reality, you have industry specific scores, custom scores and scores determined by each of the three major credit bureaus. Before looking at how a personal loan can affect your credit history, it is important to know how your scores are determined.
Your credit score will vary depending on which scoring model is used to determine your score. FICO, who offers the most commonly used formula for calculating credit scores, uses the following formula to determine your credit score (Each consideration is weighted and that percentage is included below):
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- New credit: 10%
- Credit mix: 10%
VantageScore 4.0 is another commonly used scoring model. The VantageScore 4.0 is calculated based on the following factors:
- Payment history (41%)
- Utilization (20%)
- Age/mix of credit (20%)
- New credit (11%)
- Balances (6%)
- Available credit (2%)
Understanding how your credit scores are determined can help you better understand how a personal loan and other financial products impact your credit. By building and maintaining healthy credit, you may qualify for more competitive rates and terms.
How personal loans affect your credit
The process of applying for and taking out a personal loan can affect your credit score. As can your repayment history of the loan. The following steps in the personal loan application and management process can potentially affect your credit score:
You’ll submit to a hard credit check to qualify: An unsecured personal loan doesn’t require you to put down collateral to qualify. Instead, your potential lender will review your credit report to determine whether or not you qualify for a loan. When the lender reviews your credit, you’re subjected to a hard credit inquiry.
Having too many hard inquiries on your report may have a negative effect on your score. Hard inquiries generally affect your credit score, because they help serve as a timeline of when you’ve applied for new credit. They can indicate different things to different lenders, but generally a hard inquiry may stay on your credit report for up to two years.
To minimize the impact of hard inquiries when comparison shopping with multiple lenders, it is best to do so in a short time frame. Usually, credit scoring models will count multiple hard inquiries as a single event if they are for the same type of credit product and occur in a short window of a few weeks.
You can also find lenders who offer prequalification with a soft credit inquiry. A soft inquiry won’t impact your credit scores and acts as a record of when someone checks your credit report. The difference between soft inquiries and hard ones are that soft inquiries generally occur when the check isn’t part of a credit-making decision, whereas a hard inquiry is used to make credit decisions by lenders.
With a prequalification, you can get an idea of what terms you may qualify for when shopping around for lenders. Once you choose a lender and formally apply, you’ll submit to a hard credit check.
A personal loan may improve your credit mix: Taking out a personal loan may boost your credit. Depending on what your existing credit types look like, taking out a personal loan can help you have a varied mix of credit types. Credit scoring models like FICO and VantageScore view a varied credit mix favorably, as it shows you can juggle different types of credit.
You’ll establish a positive or negative payment history with your loan: Creditors want to know that you can manage your debt responsibly over time — that’s why your payment history is an important factor in your credit score. If you make your personal loan payments on-time and in full, you can improve your credit score. However, if you fall behind on payments, you’ll damage your score.
Once you’re behind on payments, you may be considered in “delinquency” or in “default.” Debt is seen as delinquent the day after a missed payment. Default on the other hand, occurs when a borrower doesn’t pay back their debt according to the initial lending agreement.
Generally, defaulting entails missing successive payments over an extended period of time. The period between that first missed payment and going into default is what is considered delinquency. Once a debt is 30 to 90 days past due, your credit score will be negatively impacted because you may now be seen as a high-risk borrower.
Debt consolidation can improve your credit in different ways: If you choose to take out a personal loan in order to consolidate your debt, you may be able to improve your credit score.
When you consolidate debt with a personal loan, you pay down balances on high-interest debts (credit cards are a very common example) with a new loan. Debt consolidation can help you improve your credit score by lowering your credit utilization ratio, which looks at how much available credit you’re using. (Personal loan debt isn’t considered in your credit utilization ratio.) You could also use your loan to pay off delinquent debts.
If a consolidation loan helps you repay your debt, you can improve your debt-to-income (DTI) ratio over time, too. DTI is a comparison of the amount of debt you owe each month compared to your income. Lenders may consider your DTI when weighing credit options. The lower your DTI is, the better, in regards to lending; however, your DTI does not appear on your credit report and does not directly affect your credit scores.
How to borrow responsibly
Taking out a personal loan is a financial responsibility you have to be prepared to take on. Consider the following factors if you want to be a responsible loan borrower:
Know how you’ll spend the loan funds: There are some personal loan providers that don’t govern how you use your loan funds, though others may limit how it is used. Having a plan for how you’ll spend personal loan funds will help you decide not only the amount of your loan you might need, but also the lender best suited to work with you.
Calculate the amount you need: The first step in deciding if you should take out a personal loan is to determine exactly what you plan to spend the loan money on. This step will allow you to calculate the exact amount you need to borrow. You should also add on the costs of any loan fees if you don’t plan on paying for those out of pocket, or if the lender will take a cut before distributing loan funds.
Plan your monthly payments: Taking out a personal loan should not just be determined by how much money you need, but how much you can afford to borrow. To calculate how much you’ll pay monthly, take note of the initial borrowing amount, repayment length, and monthly interest rate. For help calculating your monthly payments, check out this loan payment calculator.
Avoid piling on new debt after consolidation: Consolidation may lower your monthly payments, but you should remember that your total debt load has not changed, just the way you are paying it off. If you continue to use high interest credit cards to make purchases you can’t afford or take on new debt, you will continue to hurt your financial health. Consider only using cash to make purchases while you pay down your debt. You may also want to create a new budget designed to help you manage debt as well as cover your living expenses.
Consider alternative options: Although personal loans are a flexible loan product you can use to fund various purchases or to consolidate debt, they’re not right for everyone. You need strong credit to qualify for the lowest personal loan rates. If your credit is hurting, you may not qualify for a personal loan, or only qualify for high rates.
Before taking on any new form of debt, it’s important to consider alternative financing methods to find the best option for your financial situation and needs. Consider the following:
- Using an existing credit card may be an option if you can repay the balance by the due date. This is a good option for borrowing on the fly. However, if you can’t repay the debt in full, you’ll be hit with high interest costs.
- Opening a new credit card with a 0% promotional APR is an option if you have strong credit. With this type of card, you can borrow interest-free, assuming you repay the debt before the introductory period ends.
- Getting a salary advance may be a good option if you need funds quickly but don’t qualify for competitive rates on a loan. You can ask your HR department about taking a salary advance. Some companies have payroll advance programs that are designed to help their employees cover financial emergencies. Many of these programs don’t require any fees or interest, but the terms will vary by company.
When it comes down to it, only you can decide whether or not a personal loan is a good choice for you. Arming yourself with proper financial education is a key step in making sure that taking out a personal loan won’t negatively affect your financial situation and, ultimately, your credit. Carefully weigh your options, needs and wants.
When you’re ready to apply for a loan, research lenders online and locally. Apply for prequalification with each one to see what terms you may qualify for, and read through each lender’s fee structure. Once you’ve found what looks like a good deal, you may formally apply with a hard credit check.