How a Personal Loan Affects Your Credit Score
One of the biggest personal finance myths is that having more loans means you will have a lower credit score. It’s simply not true. In some cases, the opposite is actually true. Getting a new loan can actually boost your credit score.
Credit scores are not based on what you owe: they measure how likely you are to pay it all back, among other factors. For this reason, people who use loans the right way, can actually improve their finances and their credit scores.
Let’s look at the advantages of a personal loan and how it affects your credit score from top to bottom, step by step.
Why smart people get personal loans
There are different purposes to get a personal loan. Getting a personal loan to pay for a vacation you couldn’t otherwise afford is probably your main priority for a well-deserved relaxing time out. However, using a personal loan to consolidate several high interest debts into one lower-interest loan is one of the savvier ways to get a personal loan.
Paying off a credit card debt at a 20.00% APR with a personal loan that has an 8.00% APR can reduce your monthly payments, and put more money in your pocket each month after all your bills are paid. But the advantages go well beyond saving money on interest or freeing up some spending money.
Advantages of using a Personal Loan
One big advantage of a personal loan is that they force you to pay down the debt. Anyone who has ever had credit card debt knows how frustrating it can be to pay it off. You go through an endless cycle of making payments, charging up new balances, and ending up right where you left off. Personal loans can help you get off the debt treadmill, because they don’t allow you to reborrow what you have paid off. With credit cards, on the other hand, you may stay on the debt cycle by allowing you to spend back up to your credit limit.
Personal loans can also help you save money on other types of loans by boosting your credit score, enabling you to borrow at lower interest rates and improve your total financial picture. That’s because using a personal loan to consolidate debt can have a positive impact on the most important factors that make up your credit score.
How your credit score works
Think of a credit score like a financial grade point average, or GPA. Your score can range from 300 to 850, but anything above 800 is usually considered “exceptional.” This means that although having a score above that level doesn’t necessarily makes lenders to give you any extra credit, the better you manage your finances, the stable your credit score will be.
But you don’t have to take it from us. According to FICO -- the people who calculate credit scores for a living -- a score is determined by just five factors, some more important than others.
1. Payment history (35%)
Do you pay your bills on time? As long as you avoid paying a bill more than 30 days late, you should have excellent payment history. In much the same way your current regular job evaluation is a lot more important than your long time high school test, recent payment history is way more important now than a late payment five years ago.
2. Credit utilization (30%)
How much do you owe compared to how much you could borrow? If you owe $900 on a credit card with a $1,000 limit, this indicates you may be stretching your budget, so it will hurt your score. A utilization ratio (the balance divided by the credit limit) of 30% or less is ideal; not more than 50%, recommended.
3. Length of credit history (15%)
Experience matters, whether we’re talking about personal finances or time spent in the yoga studio. It is less risky to lend to someone who has a ten-year history of making payments on time than someone who has no credit history at all, so people with longer credit histories have better credit scores.
4. Credit mix (10%)
Having different types of credit records is better than having just one type. Having a car loan and credit card on your credit report is better than having just a credit card, for example. This is a small part of your score, but it’s worth knowing about.
5. New credit (10%)
Applying for and taking out a bunch of loans or credit cards in a short period of time can hurt your score. This is because it may give the impression that you are overspending, or that you are desperate to borrow for one reason or another (like an upcoming job loss the lender doesn’t know about).
We know it. This is a lot of information to hold. Below we’ll bring it all together to show you how a personal loan could help you start or continue improving your credit score.
How does a personal loan affect your credit score
Now that you know how credit scores work, we can walk through how a personal loan can help your credit score, piece by piece. The big parts of your score are the most obvious. When you make timely payments on a personal loan, you build positive payment history that helps to increase your score. When you use a personal loan instead of a credit card, you’ll reduce your credit utilization ratio, the second most important factor in your credit score.
A personal loan can also help you build the length of your credit history and add to your credit mix a different type of credit in your credit report. In all, personal loans can help you improve factors that affect 90% of your score.
The short and long-term effects
Of course, there is a small factor that getting a personal loan won’t help. Applying for any type of loan has a negative impact on the 10% of your credit score that comes from new credit applications. However, the impact is small and only temporary.
One year after applying for a loan, the application will stop affecting your credit score. After two years, the credit application falls off your credit report entirely. Meanwhile, the benefits of having more payment history and lower credit utilization will boost your score for a long time to come. Think of it as short-term pain for a long-term gain.
Personal loans should not be used to spend beyond your means. But if they help you dodge a higher APR on a credit card, or consolidate debt to reduce your monthly payment and get a better credit score, taking out a personal loan can be a savvy financial move.