A personal loan, like any debt, can impact your credit score positively or negatively. It all depends on how you manage that debt. Understanding the effects a personal loan can have on your FICO score will empower you to utilize loans to your advantage.
Positive Effects of a Personal Loan on Your Credit Score
Easy Opportunity to Increase Your Payment History
If you have no payment history or very little, a personal loan from a reputable lender can help you demonstrate your ability to repay a debt, thereby increasing your FICO score.
Personal loans are relatively easy to obtain because they usually do not require collateral. Personal loans have typical terms from 12 months to 60 months, so they are a short-term loan with simple interest. Personal loans do not depend on a particular purpose. In other words, you don’t have to prove that you’re buying a car or paying for school to obtain a personal loan. You can take out a personal loan just to establish or increase your payment history.
Improve your credit history by paying off your personal loan with automatic payments. Talk with your lender about setting up autopay.
Easy Opportunity to Demonstrate Your Creditworthiness
Being creditworthy is all about paying your bills on time and paying your loans off to reduce your debt-to-income ratio.
Personal loans are small, finite sums of money, so they can be easily managed by novice borrowers.
Personal loans are charged simple interest. That means as long as you pay your monthly installment on time, incurring no late fees, neither the principal nor interest will increase.
Demonstrate your creditworthiness to future lenders by handling a personal loan like an pro. Set up automatic payments if possible and never miss a payment again.
Easy Opportunity to Diversify Your Debt Portfolio
If you already have one or more credit cards, categorized as a revolving line of credit, you are on the right track. But lenders want to know that you are equally prepared to make timely payments on an installment loan.
Personal loans are installment loans, so making your monthly payments on time demonstrates your ability to utilize various types of credit successfully.
Make payments on your installment loan on time every time when you sign up for automatic payments.
Negative Effects of a Personal Loan on Your Credit Score
As with any debt, the opportunity to make mistakes that can negatively impact your credit score exists. These are the ways that taking a personal loan could cause more harm than good.
Missed or late payments
Taking a personal loan can alleviate an immediate financial hardship. But if you cannot make payments on time, you should explore other options, such as taking a second job or starting a side hustle. Poor payment history carries more weight than any other aspect that contributes to your credit score.
Bottom line: Only secure a personal loan if you know you can make the payments on time every month.
Too much debt
Obtaining a personal loan is relatively easy, so it is tempting to use personal loans to purchase luxuries that you really cannot afford. The number of loans and amount of debt you have negatively impacts your debt-to-income ratio, which is the second most important factor when lenders evaluate your creditworthiness.
Bottom line: Only take a personal loan if you need the money immediately or if you need to increase your credit score (and it won’t negatively impact your payment history or new credit).
Too many credit inquiries or new accounts in a short period of time
Applying for too much credit—credit cards, personal loans, student loans—tell a lender that you have overextended your income. If you have multiple credit inquiries or new accounts in a short period of time, it appears as if you are spending more money than you make. Credit inquiries and new accounts stay on your credit report for two years, so be wary of applying for more than one or two credit cards or loans in any two-year period.
Bottom line: Only apply for credit of any kind when the advantages outweigh the disadvantages.
Personal loans are a tool that, when used appropriately, can help you reach your financial goals. If you want to learn more about how a personal loan will impact your FICO score, schedule a consultation with a loan specialist at AMG Finance.
