Whenever you borrow money, there’s a risk of hurting your credit score, but if managed correctly, a personal loan may actually help your credit. Before deciding whether you should get a personal loan, be sure to understand your credit situation and how a personal loan can affect your credit score.
How is My Credit Score Determined?
A credit score is one of the first things a lender will look at when considering your application for a loan. Your credit score is the key factor in determining your creditworthiness — how likely you are to pay back the loan on time.
There are many factors that go into what makes up your credit score, but all scores fall between 300 and 850. A higher score gives you a better chance of securing a loan. While score ranges vary, this is generally how credit scores are categorized:
- 800 and above is excellent. If you have a score this high, it means you’ve demonstrated responsible credit behavior and have a strong credit history.
- 740 to 799 is very good. With a score this high, you will have a better chance of getting low loan rates.
- 670 to 739 is good. This score means you’re a lower-risk borrower, so you are likely to qualify for a loan, but most likely at a higher rate.
- 580 to 669 is fair. Borrowers with scores in this range are considered “subprime.” While you may still qualify for some loans, they would likely have higher interest rates.
- Under 580. With a score under 580, it will be difficult to qualify for a loan. If you are able to borrow money, the interest rate would be high.
How to Check Your Credit Score
All three major credit reporting agencies — Equifax, Transunion, and Experian — allow you to check your credit score once a year for free. Some banks and credit unions also allow you to
check your credit score an unlimited number of times throughout the year.
When you check your score, you’re doing what is called a soft inquiry. A soft inquiry happens when you check your credit score or when a potential lender checks your credit to preapprove you for a loan. These checks are not part of your credit history.
To go even deeper into your credit profile, you can also request one free annual credit report from AnnualCreditReport.com. When you review your credit report, make sure to check for and fix any credit errors.
Do Personal Loans Help Build Credit?
If managed correctly, a personal loan may be highly beneficial for your credit score in the long run. Here are the ways taking out a loan could help.
You Can Consolidate Your Debt at a Lower Rate
It may be surprising to learn that getting a personal loan may positively impact your credit score. For one thing, it can be a great way to consolidate debt at a lower rate than what you may be currently paying.
Let’s say that you have $25,000 of debt on a credit card that charges you 25% annually. If you take out a $25,000 personal loan at 7% and use it to pay off your credit card debt, you still have the same amount of debt. However, now your interest rate is much lower. Even if you pay the same amount on that loan every month as you did when your interest rate was 25%, most of the money you pay is going toward paying down principal, rather than paying interest.
You Have Debt of a Different Kind
Did you know having a debt of a different kind is positive for your credit score? When you take a personal loan, you pay it off in installments of regular monthly payments. This is a predictable expense. With a credit card, your payments can balloon over time and are less predictable. This is known as “revolving debt.”
You Build Payment History
One surefire way of boosting your credit score is by creating a history of paying your bills on time. Making the monthly payment on your personal loan creates a positive payment history.
You Bring Down Your Credit Utilization Rate
Your credit utilization rate determines how much you could be borrowing versus how much you are currently borrowing. By using a personal loan to pay off and close credit cards, you’re reducing your amount of revolving debt which helps to lower your credit utilization ratio.
Do Personal Loans Hurt Your Credit?
Whenever you take out a loan, there is initially a small negative credit impact, and if you don’t manage your loan correctly, it can get worse. Now that you know the ways a personal loan can build your credit score, let’s talk about some of the potential drawbacks.
Your Credit Score Gets a Hard Inquiry
It’s an unavoidable fact that any potential lender will perform a hard inquiry on your credit when you apply for a personal loan. Unlike a soft inquiry, a hard inquiry causes a slight decrease to your credit score. However, this dip should only last for a few months.
You Risk Missing Payments
Getting a personal loan may be one of the smartest financial moves you make if you use it to pay off a credit card or other higher interest rate debt. But you must exercise good judgment with how you spend a personal loan. A lender provides a loan for you to use as you see fit. It is up to you to use the loan responsibly and pay it back on time. Missing payments will hurt your credit score.
Should I Take Out a Personal Loan?
Sometimes, unforeseen expenses — like home repairs or medical expenses — can unexpectedly crop up in your life. A personal loan can be a great way for you to cover those costs without putting them on a high-interest rate credit card.
Despite the potential risks, a personal loan can be the smart way to get the money you need to finally take control of your finances.