How Personal Loans Affect Your Credit Score

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How Personal Loans Affect Your Credit Score

A personal loan may have an impact on your credit score in a variety of ways, both positive and negative. Taking out a personal loan is not inherently harmful to your credit score. However, it may have a short-term impact on your total credit score and make it more difficult to receive further credit until the new debt is paid off.

Paying off a personal loan on time, on the other hand, should improve your total credit score. If you decide to take out one, be sure to properly study and evaluate all of your alternatives in order to qualify for the best loan available.

Key Takeaways

  • When you take out a personal loan to consolidate debt, your total credit score may suffer briefly.
  • Repaying the debt on time will not only restore your credit score, but will also assist to grow it over time.
  • You may be unable to get another loan or start a new credit card in the near future.

What Factors Into Your Credit Score

To understand how a personal loan impacts your credit score, you must first grasp how the score is created. FICO, developed by the Fair Isaac Corporation, is the most extensively utilized credit score among lenders. FICO scores vary from 300 to 850.

Payment history, amounts outstanding, duration of credit history, new credit, and credit mix are the five characteristics used to construct credit ratings. The precise percentages may vary among the three main credit rating agencies, but according to FICO, below is a breakdown of how much weight each element carries in the calculation:

  • 35% is determined by your payment history.
  • The 30% is calculated depending on the entire amount of your outstanding debt.
  • The percentage is determined by the duration of your credit history.
  • 10% is applied to any new debt or new lines of credit.
  • 10% is based on credit mix—the number of open credit lines (including secured credit cards)
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The three main credit reporting agencies used by lenders in the United States—Equifax, Experian, and TransUnion—provide identical creditworthiness ratings, although there may be minor variances.

Does Applying for Loans Affect Your Credit Score?

As you can see, receiving a new personal loan may have an impact on your credit score. Your existing debt has grown, and you have taken on additional debt.

New financial activity is noted by credit agencies. If, for example, you attempted to arrange for a new vehicle loan soon after taking out a personal loan, your application for a car loan may be denied on the grounds that you already have more debt than you can manage.

A single new loan has less of an influence on your credit score than your complete credit history. If you have a lengthy history of managing debt and making on-time payments, the effect of a new loan on your credit score is likely to be mitigated. Making on-time and within the conditions of the loan agreement is the simplest and most effective strategy to protect a personal loan from reducing your credit score.

How a Personal Loan Can Boost Your Credit Score

A personal loan that you return on time might help your credit score since it displays that you can manage debt responsibly.

People who are most hesitant to take on debt may have poor credit ratings. A person with no payment history has never incurred debt and has never paid it off in installments.

Every 12 months, you may get a free copy of your credit reports from the three credit agencies by visiting www.annualcreditreport.com.

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What Credit Score Is Needed for a Personal Loan?

As previously stated, credit scores vary from 300 to 850. A lender is more likely to accept your loan application and give more advantageous conditions, such as a reduced interest rate, if your credit score is better. While each has its own set of standards, lenders generally consider scores over 670 to be a sign that a person is creditworthy.

FICO scores are classified into five levels: bad, fair, excellent, very good, and outstanding. The following is a breakdown of the ranges:

  • Poor (580): Your credit score is below average, and lenders will see you as a hazardous borrower.
  • Fair (580-669): This score is below average, but many lenders may still accept loans with it.
  • Good (670-739): This score is considered good by most lenders since it is around or slightly over average.
  • Very Good (740-799): Above average, demonstrating to lenders that you are a trustworthy borrower.
  • Extraordinary (800+): You are well above average, and lenders will consider you an exceptional borrower.

According to Experian, one of the credit rating organizations, the majority of Americans (69%) had a credit score of excellent or above in 2020. The average credit score reached a record high of 710.

Keep in mind that, although your credit score is important in determining your eligibility for a personal loan, lenders also evaluate other variables such as your salary, how much money you have in the bank, and how long you have been working.

Finding the proper loan might be especially difficult if you are in a financial emergency and need to borrow money quickly. If you have terrible credit, you may find it much more difficult to get cash immediately. Fortunately, even if you have bad credit, you may be able to get an emergency loan.

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The Bottom Line

A personal loan can reduce your credit score temporarily, but making on-time payments will restore it and help you develop credit. The important thing is to return the loan on time. A personal loan calculator may be of great assistance in calculating the best loan repayment period for you.

If you pay late or default on the loan, your credit score will suffer. Also, keep in mind that a personal loan may lower your borrowing capacity for other lines of credit. If you recently took out a personal loan and made many late payments or defaulted on it, one of the top credit repair agencies may be able to erase the bad points from your credit report.

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