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By Lois Sullivan
Personal loans are very versatile. You can use them for almost anything: emergency expenses, home improvements and more. They’re also good for consolidating multiple loans or credit card debts into a single monthly payment. Instead of worrying about paying different bills at different times and rates, consolidation could help simplify your payments.
However, a personal loan could help or hurt your credit score, depending on your actions. When you use a personal loan in a smart way, it can help your credit score. But in some circumstances, a personal loan could hurt your credit score. So before you apply for a personal loan, it's a good idea to understand your credit score and how a personal loan could affect it.
Most lenders consider your credit score and credit history before deciding on the rates and terms for a personal loan or another kind of loan. Three credit bureaus in the United States, Experian, Equifax, and TransUnion, record credit scores and credit reports about potential borrowers. Lenders usually divide credit scores into these categories:
Your credit score is calculated from your credit history, and you can get detailed copies of your credit reports from the credit bureaus. The credit bureaus use slightly different methods to calculate credit scores, but they all base about the same percentages of their scores on these criteria:
Understanding your credit score lets you predict the interest rate you'll get for a personal loan and compare offers from different companies. For more detailed information, you can check your credit reports (you can get free detailed copies of your credit reports every 12 months from any of the credit bureaus). You can request a copy from AnnualCreditReport.com. If you notice any errors or inaccurate information, you can raise your credit score by disputing it. Learning more about your credit history also makes improving your credit score easier.
Negative payment history. At 35 percent, payment history is one of the most important factors in your credit score. If you don’t make your personal loan payments on time and in full each month, your credit score could take a dip. It’s important to evaluate the monthly payment before opening a personal loan.
Another credit inquiry. When you apply for a personal loan, the lender usually performs a hard inquiry on your credit report. A hard inquiry could temporarily reduce your credit score by a few points. When you apply for any loan, it’s good practice to ask up front if the credit check is a hard or soft inquiry.
Instead of applying for several loans, consider getting prequalified. When you prequalify for a personal loan, the lender often performs a soft credit check that doesn't change your credit score. You won't get a guaranteed rate until you complete an application, but prequalifying lets you get an estimate of your rate and monthly payments for which you may qualify. That way, you can compare different loans without lowering your credit score by applying for all of them. When you're ready to apply for your first choices, keep your applications within one or two weeks of each other to minimize the impact on your credit score.
Increasing your debt-to-income ratio (DTI). Your DTI matters for two reasons. If it’s too high, it can prevent you from opening a new loan like a mortgage. Also, if it’s too high, it could put you in a stressful financial situation. Even though DTI is not a factor in your credit score, you should calculate your DTI before opening a new loan. A healthy DTI is below 40 percent.
Positive payment history. Even when you get a personal loan for home improvements, a fun vacation or another expense, you can use that loan to improve your credit score by making your payments on time. Paying on time helps build your payment history, which is 35 percent of your credit score. It demonstrates to lenders you can honor your responsibilities and pay for your debts. This is especially true if you have never had a loan before.
However, if you have a low credit score or a short credit history when you apply for a personal loan, you may need to pay a higher interest rate. While your credit score may drop slightly right after you apply for a personal loan, it could rise as you make your payments on time.
A lower credit utilization ratio. If you use a personal loan to consolidate credit card debt, you could lower your credit utilization score. Credit utilization makes up 30 percent of your score. Credit utilization comes from your revolving lines of credit (i.e. home equity lines of credit and credit cards). It is the ratio of how much you owe compared to your total credit limit amount. For example, if you have two credit cards with a total credit limit of $5,000 and you owe $4,000 at the end of the month, your credit utilization is 80 percent.
When you consolidate credit card debt with a personal loan, you move the debt from the revolving line of credit (the credit card) to the personal loan. In the same example, if you move all $4,000 to a personal loan, your credit utilization would become 0 percent. It’s best practice to keep it under 30 percent, so moving debt from a credit card could give your score a big boost.
Another type of credit. Getting a personal loan can also raise your credit score by improving your credit mix or the variety of credit accounts you have. These accounts can include mortgages, credit cards, lines of credit, vehicle loans, home equity loans and other forms of credit. Having a good credit mix and a good payment history shows lenders you can handle many different forms of debt. Your credit mix is worth about 10 percent of your credit score.
Slowly lowering your debt-to-income ratio. Debt-to-income is not part of your credit score, but lenders typically look at it when you apply for a loan or credit card. To calculate your DTI, take your total monthly debt payments and divide it by your monthly income. You may be wondering, how can taking on a new loan help your DTI ratio? In the long run, if you are using a personal loan to consolidate high-interest debt into a lower-interest loan, you may be able to pay off your debt quicker. As you pay off your debt, your debt-to-income ratio may decrease (as long as you’re not taking on new debt).
Note: Even though you may see credit score improvements in the examples above, you should never take out a loan for the sole purpose of raising your credit score.
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