Taking out a personal loan can feel counterproductive to getting out of debt, but there are times when it can be a way to positively affect your credit score.
If you are using a personal loan to help pay off credit card debt by consolidating it or paying off a major life event, such as a wedding or medical bills, it can be a useful tool.
You should only borrow what you need. Don’t take out a personal loan without a set plan on how to pay it off as quickly as possible.
Personal loans are a form of installment credit given in a set amount. With personal loans, interest rates are typically lower than with credit cards, which use revolving credit.
When used to consolidate debt, a personal loan can help to save you money over time by lowering your interest rates and making it easier to manage your monthly payments. If you miss payments, are late on payments, or a personal loan only serves to increase your overall debt, it can hurt your credit score.
A personal loan can be both a detriment and a boost to your credit score depending on how it is used.
How Do Personal Loans Affect Your Credit?
There are five main categories that are used to determine your FICO credit score:
- Payment history: 35%
- Amounts owed: 30%
- Length of credit history: 15%
- New credit: 10%
- Credit mix: 10%
A personal loan is a form of installment credit, just like auto loans, student loans, and home loans. This means that you borrow a set amount and then have a fixed time to pay it back, with structured monthly payments to do so.
This is different from credit cards, which use revolving debt. With a credit card, you can borrow up to a certain line of credit, make a payment, and then borrow that money again.
Having different kinds of credit can actually help to boost your credit score as long as you keep your overall debt and amount owed low. It can be helpful to have a mix of credit, including both an installment loan and revolving credit, to improve your overall credit score. You just need to be careful not to borrow too much.
Most of your credit score is based on your payment history, so the biggest impact on your credit report is going to be whether or not you make your payments on time and in full. Pay your monthly bills on time? Your credit score goes up. Late, delinquent, or missed payments? Your credit score goes down.
When a Personal Loan Can Help Your Credit Score
When borrowing responsibly, using different types of loans – such as a personal loan and credit cards – can enhance your credit score. Responsible borrowing means only taking out what you need, making your payments on time, and paying off your debt as quickly as you can.
One of the best reasons to take out a personal loan is for debt consolidation. If you have several high-interest credit cards with balances, for example, you can often get a personal loan with a lower interest rate to pay these off. You can save up to 50% in interest over time by using a personal loan to pay them down.
Debt consolidation can make it easier to manage your monthly payments by rolling multiple monthly bills into one bill and one payment. Consolidation can also improve your credit score by improving your credit utilization ratio – that is how much money you borrow and how much of your personal credit you are using. The more of your available credit you are using at a time, the lower your credit score can be. Similarly, the less you owe, the higher your score.
Protecting and Improving Your Credit Score
A personal loan is an unsecured loan, which means that it doesn’t use collateral like a car loan or home mortgage does, and it can be used for just about anything. You should be careful when considering a personal loan as it can impact your credit in good or bad ways depending on how you use it.
There are negative impacts of a personal loan:
- The credit inquiry included with the loan application can temporarily lower your credit score.
- Delinquent payments can drag your credit score down.
- Too much debt can be harder to pay back.
- Extra fees, like a loan origination fee, can add up.
The average person in the United States has about $40,000 in personal debt, not counting home mortgages. Between car loans, student loans, credit card debt, and personal loans, it can be easy to get into debt that quickly feels out of reach. Debt consolidation and a personal loan can be helpful tools to manage your debt if you use them carefully.
If you have a major expense, such as medical bills, a home improvement project, or high-interest credit cards, a personal loan can help you to get a handle on your bills. If you do decide to take out a personal loan, look for a short-term loan that you can pay off quickly. The lower the interest rate, the better.
Only borrow what you can afford to pay back each month. Make sure you are going to be able to manage the monthly payments, so you can improve your credit score instead of harming it.