A personal loan can be a smart solution if you need an infusion of funds quickly to pay for expenses. This type of loan can help you cover home repairs, consolidate high-interest debt, or make a large purchase.
Your credit is closely tied to your eligibility for a personal loan, as well as what happens after you borrow and begin repaying it. Here’s the details on how a personal loan affects your credit score.
A personal loan is an installment loan, where you take out a fixed sum of money and make monthly payments for a specified period. These types of loans can be used for myriad reasons, including debt consolidation or paying for unexpected expenses (medical bills, for example) or planned costs (a wedding).
Personal loans can be either secured or unsecured. An unsecured loan doesn’t need to be backed by collateral — you qualify based on criteria, such as your credit score and debt-to-income (DTI) ratio. If you qualify for an unsecured loan, it’s a less risky way of borrowing, however, you may pay more interest.
Contrast this to a secured loan, where you’ll need to back up your loan with an asset, such as your home or vehicle. While this type of loan can cost you less in interest, you could end up paying a steep price if you default on the loan and forfeit your collateral to the lender.
Personal loans can have either fixed rates, where the interest rate remains constant throughout the life of the loan, or variable rates, where the interest can fluctuate. A variable interest rate can work in your favor or against it, depending on the market.
Depending on how you use your personal loan, it can positively affect your score. Some of the ways in which a personal loan can impact your credit score include decreasing your credit utilization ratio and building credit history.
If you consistently make on-time payments on your personal loan, it can improve your credit score. It shows lenders you’re responsible with your payments, leading to positive remarks on your credit report.
Your payment history is one of the most important factors in determining your credit score. So much so that 35% of your FICO score is based on your payment history.
Taking out a personal loan could improve the mix of credit you have, whether it’s a combination of mortgage loans, credit cards, or other installment loans. Having a variety of debt types makes up 10% of your FICO score.
Think of it as a way for lenders to see how you manage different loans. The more types you have, the more a lender can assess your risk profile as a borrower.
| Tip: Before applying for a personal loan, try to decrease your credit utilization ratio. This ratio compares the available revolving credit (such as for credit cards) you have versus how much if it you’re using. The lower the percentage, the more positively it could affect your score, as it demonstrates that you’re not overextended financially. Credit utilization is one of a few factors that falls under “amounts owed,” which makes up 30% of your FICO score. |
Because your credit score is based on your financial behavior, a personal loan can also negatively impact your score. Some of these behaviors can include applying for too many loans and having a high DTI ratio.
Each time you submit a loan application, you could be subjected to a hard credit inquiry, where lenders will review your credit score and history. This could adversely affect your credit score, especially if you apply for too many personal loans over an extended period.
If you’re shopping around for personal loans, many lenders only perform soft credit inquiries, where you can check your rate and eligibility without affecting your credit. Checking rates through a soft inquiry won’t affect your credit, so you can compare multiple lenders without worry.
After prequalifying — and once you identify your preferred lender — then it could be worth filing the more formal application that may temporarily ding your credit score.
Related: Learn more about getting a personal loan on Credible.com
Your debt-to-income, or DTI ratio, is a measurement lenders look at to assess whether you can afford to take on the payments for a new personal loan. Calculating DTI involves taking your total monthly debt obligation and dividing it by your gross (or pre-tax) monthly income.
For instance, if you earn $5,000 in gross monthly income and pay $2,000 per month toward all your combined debts, your DTI is 40%.
$2,000 / $5,000 = 40% DTI
The higher your DTI, the more it appears you’re being stretched too thin financially, which could affect your score negatively. On the other hand, a lower DTI shows you’re more likely to handle loan repayment as well as your other monthly debt obligations.
Depending on the lender and the type of personal loan you apply for, you may be subject to DTI limits. It’s best to check with lenders to see what you may qualify for (perhaps via prequalification) before submitting an application.
Considering that your payment history is a major factor in calculating your credit score, even one late or missed personal loan payment can place a negative remark on your credit report. In this case, it can lower your credit score.
The cure, of course, would be following up a late payment with a long string of on-time and in-full payments, until your balance hits zero.
Several reasons you may consider taking out a personal loan include:
When applying for a personal loan, it’s important to know what your credit score is, as it plays a major role in whether you’ll qualify.
In many cases, lenders will have minimum credit score requirements, which vary depending on factors such as the type of loan and the amount you want to borrow. Typically, you can qualify for a loan that falls in the good credit score range, around 700 or higher.
That being said, the higher your score, the more likely you’ll receive more competitive rates and terms for a personal loan. Some lenders are willing to work with borrowers with lower credit scores, but loan amounts may be smaller with higher interest rates.
Here are the steps you’ll need to take to complete a personal loan application:
- Compare multiple lenders: Prequalifying to check APRs (rates accounting for lender fees) from a few different lenders will help you find the right fit. Don’t forget to compare eligibility requirements and repayment terms, too.
- Choose a lender: Once you’ve shopped around, pick the best lender for you. Then you can submit a formal application that verifies the information you provided during pre-qualification. You might be asked for proof of income and tax returns, for example.
- Complete the closing process: If the lender approves your application, you’ll need to sign any necessary closing documents so you’ll be able to receive the loan proceeds. While some lenders may fund approved loans as quickly as the same or next business day, others may take up to a week after your application’s approval.
Related: Learn more about getting a personal loan on Credible.com