There is certainly a lot of static around the subject of how personal loans can impact a credit score. The truth is that there is no universal answer to this question. The impact itself is highly dependent upon a wide range of variables.
To put it another way, how a personal loan impacts your credit score is largely up to you.
What Exactly Is A Personal Loan?
There are a variety of reasons why someone might need a personal loan. It all essentially comes down to finding yourself amid a financial emergency. It is a curious situation where a consumer tackles debt by taking on more debt. While that doesn’t sound very effective, a personal loan can indeed be a lifesaver under the right circumstances.
“Under the right circumstances” would be the key phrase here. A personal loan, when carefully researched and utilized, can accomplish two things. It can help you to deal with your immediate financial needs, including paying off more problematic debts.
A personal loan is a different type of loan altogether. Unlike borrowing money for homes or cars, a personal loan is defined as a consumer loan. This means you can spend it on whatever you like.
You will also find that there are tons of lenders out there offering many different types of financing products. Banks and credit unions are two options. Some choose to get a personal loan through an online lender. Be wary of online lenders who sound too good to be true. Research is extremely important in this regard. You want to have a complete understanding of what is being expected of you in the terms and conditions of your loan.
If you can meet those terms and conditions, the impact on your overall credit score can prove to be highly favorable — read more here.
Before we look into how personal loans affect credit scores, let’s run down the most important considerations of choosing a loan like this in the first place.
How To Get The Most From A Personal Loan
The good news about personal loans is that they are available to just about everyone. The bad news is that not all lenders are created equal. Furthermore, certain factors can also impact the types of personal loans available to you. That includes the interest rates attached to the loans themselves.
Here are a few quick things to keep in mind, when it comes to shopping for a personal loan:
- Borrow only what you need. Even under the best terms and conditions, a personal loan is still not a particularly ideal situation. Focus only on what you need.
- How’s your credit? Knowing your current credit score can be useful for two reasons. Number one, it will give you a good idea of the interest rates that will likely be offered to you. Number two, it will help you to determine if you should even pursue a personal loan at all. If your credit isn’t ideal, and you aren’t sure you can meet the conditions of the loan being offered to you, the personal loan might not be for you.
- Research your lenders. This cannot be overstated. Make sure you are working with an established, well-regarded lender. A good starting point would be anyone you’re already doing business with. Banks are one example.
- Online lenders are a legitimate concept. Unfortunately, there are a lot of disreputable, predatory companies out there, so be careful.
Now, being in the best position possible to get a worthwhile loan, we can start to break down exactly how it might impact your credit.
The Pros Of Personal Loans On Your Credit
Depending upon how you use the loan, as well as how you pay off the loan, here are some of the ways it can benefit your credit score:
- A stronger overall credit mix: Believe it or not, but having different types of credit can strengthen your score. Remember that personal loans are also a type of installment loan. The more diverse your credit is, the better.
- Building a history of payment: A major influence on your credit score is your history of how and when you make payments on various loans and outstanding debt. You want your history to be a positive one. Paying off a personal loan on time can ensure that will be exactly what you build.
- Credit utilization ratios: A credit utilization ratio refers to how much of your available revolving credit is being used. A personal loan doesn’t count as revolving credit. In other words, if you’re using your personal loan to pay off revolving credit, you’re also bringing down your credit utilization ratio. This in turn positively impacts your credit score.
These are all legitimate benefits of a personal loan. At the same time, there are some significant potential downsides you will need to keep in mind:
The Cons of Personal Loans on Your Credit
Here is a closer look at the potential downsides of a personal loan on your credit:
- Credit reports: With personal loans, the lender is naturally going to want to take a closer look at your credit history. Known as hard inquiries, these background checks are going to dive into not only your credit score but the factors that have influenced your current score, as well. No matter what, such an inquiry is going to cause your score to briefly drop for a month or two. A problem can be created when you apply for several loans with several lenders. Your best bet for offsetting that, because you probably will need to apply to multiple lenders, is to apply with your preferred lenders within the shortest amount of time possible. This minimizes the damage done to your credit score.
- Bad spending habits: Let’s say you’ve completely maxed out one of your credit cards. A personal loan can be an effective means of paying that down before your finances spiral out of control. However, a personal loan also means taking on more debt. If you take on the additional debt, only to repeat the spending habits which maxed out the credit card in the first place, then you’re going to be worse off than you were before.
- Don’t forget about those extra fees: When trying to decide if a personal loan is right for you, remember that these loans always come with additional fees. They aren’t hidden, but they may not occur to someone who has never taken out a personal loan before. When you’re making sure you can pay off your persona loan in a timely fashion, make sure you are keeping in mind any additional fees. If you don’t, you could find yourself in a position of not being able to pay off the personal loan, simply because you didn’t account for additional fees in your budget.
At this point, you should have all the tools you need to figure out if a personal loan is right for you. In that same spirit, it can also be helpful to compare these factors to why you need the loan in the first place.
Making Sure You Need Your Personal Loan
A big step is to take what you need the loan for and run that through the gamut of keeping in mind everything we have discussed in this article. While the money is yours to do with as you please, the particulars of these loans are still ultimately such that they should only be used in what might be defined as an extreme situation.
What are some examples of such a situation?
- High-interest debts: You may have a debt where the interest rates amount to a sum greater than what you would have to contend with by using a personal loan to pay down that high-interest debt. If this is the case, consider a personal loan.
- Expensive emergencies: Do you suddenly have to miss work for one reason or another? That doesn’t mean your debts and expenses will come to a stop. You may also find yourself dealing with the associated costs of a recent injury and/or accident. Any of these situations can create a strong need for a personal loan.
- Home improvement: The long-term benefits of tackling one or several significant home improvement projects can make for a long list indeed. It can certainly and very dramatically increase the overall value of the property, for example. For some, such long-term perks can certainly outweigh the short-term costs of a personal loan.
Some even use these loans to pay for things like weddings or vacations. That is entirely up to you. However, it is generally a good idea, unless you have unshakable confidence in your ability to repay the loan, to use these loans for emergencies or long-term financial advantages.
By now, you have the basics of everything you need to consider a personal loan. As you can see, there are several scenarios in which these loans can be highly useful.