The process of applying for a personal loan may initially hurt your credit score. However, a personal loan can actually help improve your credit score over time. Read on to find out how applying for a personal loan can affect your overall credit picture.
How loan applications impact your credit
When you apply for a personal loan, lenders will assess your credit score and history to determine your credit risk, or your creditworthiness. To do this, they’ll run a hard credit check. When they run this check, they’re looking for indicators of financial health, like low credit balances and a good debt-to-income ratio. Whether or not you’re in good financial standing, you’ll likely see a few points knocked off your credit score as a result of the hard check.
If you’re applying for a personal loan, you likely won’t be able to avoid a hard credit check. However, the long-term investment of a personal loan can be worth it in comparison to the few points you may lose.
Can personal loans help your credit?
Under the correct circumstances and when used responsibly, a personal loan can absolutely improve your credit health. Here are a few ways in which a personal loan can positively affect your credit score:
Debt consolidation: If you use a personal loan to consolidate debt, you can generally take advantage of lower interest rates than you’d get with credit cards. With a lower interest, you may be able to pay down outstanding debt faster, which will improve your credit score.
Payment history: When payments are made in full and on time, a personal loan can help establish a positive payment history. A positive payment history makes up 35 percent of your FICO score, the largest category in determining your score.
Can personal loans hurt your credit?
While personal loans can help your credit score, they also can hurt your it if you’re not prepared to pay them off. Here are some risks you need to consider before applying for a personal loan:
Hard inquiry on your credit: Due to the hard credit check, you will likely see a short-term drop in your credit score when you formally apply for the loan. While this may not be detrimental to your long-term credit score, it could cause some harm to your credit if you apply for multiple loans in a short period of time.
Potentially high interest rates and fees: Depending on your creditworthiness, you could end up getting stuck with a considerably high interest rate and fees. The higher the interest rate, the longer you may be paying off the loan — and if you can’t afford those rates in the long term, you risk falling behind on payments and damaging your credit score.
Getting into more debt: Every time you apply for a loan, you are borrowing money, which does have the potential to put you further in debt — especially if you continue to rack up credit card balances while paying off your loan. While not all debt is necessarily a negative thing, it’s important to do an analysis of your current financial situation before applying to determine if a loan is a move in the right direction.
What to consider before taking out a personal loan
Before taking out a loan, consider the benefits and drawbacks of adding another monthly bill to your budget. A few things to think about are:
Why you’re taking out the loan: Are you interested in a personal loan to pay for a vacation or a luxury item? If this is the case, consider whether it makes more sense to save up for the item than apply for a loan. Depending on the interest rate, you could be paying off that vacation for a while, and you’ll be paying extra in the form of interest.
Your credit score and history: Do you have a good credit score and healthy habits with your credit? If not, there are things you can do to improve your credit score by putting some of those bad habits to rest.
Your debt-to-income ratio: Your debt-to-income ratio, or DTI, measures how much monthly debt you have relative to your monthly income. Generally, the higher the DTI ratio, the less likely you are to qualify for a loan. To calculate your DTI ratio, you can use Bankrate’s debt-to-income ratio calculator.
All of your options: Shopping around for the best personal loan for you is one of the most important steps to take. Each lender offers different rates, fees and conditions. The best way to find out how much you’d be paying every month is to explore all of your options.
The bottom line
Personal loans can be a great tool that can help you improve your credit score, consolidate credit card debt or pay off medical expenses. However, it’s important to be aware of how applying for a loan can affect your credit score. While you may experience a short-term dip when you submit your application, you could potentially improve your credit score over the long run by making timely payments and using your loan funds to pay down existing debt.
Featured image by fizkes of Shutterstock.
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