The first step in credit knowledge is understanding what a personal loan is and the relationship between it and credit score.
A personal loan is credit offered by credit unions, banks, or digital lenders to help you start a small business, make a big purchase, or meet individual needs.
Personal loans have a lower interest rate, which is the main reason many people go for them. So, does a personal loan affect your credit score negatively? Let’s find out.
How It Affects Your Payment History
Your behavior directly affects your loan and determines how well you are going to utilize it.
Let’s assume that you apply for a loan and divide it into small regular payments. Paying that loan within the agreed time-frame improves your credit score, while making late payments affects it negatively.
Payment history is the most significant factor when determining a credit score, and even a single late payment can lower your score drastically. It can take months of on-time payments or even years to maintain your good credit score or raise it.
If you are planning to repair your score, taking a personal installment loan, using it responsibly and paying it on time could be one way to do that. If used irresponsibly because of one’s poor behaviors, then that might negatively affect your credit score.
How A Personal Loan Affects the Total Amounts Owed
When one takes personal credit, you add the total owed to the lenders. Taking off more loans results to your debt load going up. This can lower your credit score in the short term.
However, if you have a good credit history, it shows you manage your debts efficiently, which shows potential lenders you are a good debtor. As a result, you can get a personal loan easily which can help you pay outstanding loans if any, which positively affects your credit score.
Credit Mix and Length of History
Despite these two factors being less critical compared to your amounts owed and your payment history, they are still significant areas where taking a personal loan can affect your credit score either negatively or positively.
Your credit mix is determined by the type of loans you took in the past. It looks at how diverse your mixing of loans is.
For instance, if you have a personal loan and another type of loan, taking a car loan can help your credit score since it shows that you are using another new kind of loan. If you have a personal loan and take another one, this could negatively affect your score since it shows that you are not diverse. The more varied you make your credit mix, the more positively it will impact your credit score.
For your credit history length, most personal loans come with an extended repayment period. So, the longer the time you’ve been paying back your loan, the older your credit account gets. Old credit accounts show you have been maintaining good relations between you and your lenders for a long time, which can in return help your credit score.
Here’s the catch though. After you finally pay off your loan entirely, it could lead to your credit score dropping. This mostly happens when you close your account. This is because, by closing your account, your history drastically reduces, which hurts your credit score.
This is one reason you shouldn’t close old credit accounts. The age of your accounts helps you increase your limit, which means lenders offer you a bigger loan that improves your score.
Taking A Personal Loan Leads to Credit Checks
When you apply for a personal loan, your lender must run a hard check on your credit history. For lenders to get full details of your credit, they access credit reports and get full copies of them. It’s usually a standard procedure that lenders have to perform before issuing any loans.
The disadvantage of credit inquiries decreases your score. It usually drops it with about five points or fewer, and the effect ends in a year. However, you can’t deny that when taking a personal loan, going through this part of the process can still lower credit score.
Weigh Your Credit Score Before Taking Personal Loans
Taking a personal loan can be good when you intend to use it to pay another loan or make some large purchases or cater for expenses like a wedding.
Before you make applications for any personal loan, ensure that you thoroughly analyze your current debt situation, the loan terms, and ensure you can pay the monthly installments.
Doing a prior analysis and paying your debt on time can help you increase the odds of you getting amazing personal loans and keeping your credit score high.
How Interest Rates Can Affect Your Score
Different lenders have different interest rates. It is possible to get a lender offering a loan and charging high rates, but still find another lender offering the same type and amount of loan at preferably lower rates.
One way to avoid taking a personal loan is by negotiating with your lender on the rates and installments to a better and manageable scenario.
Before taking a loan, consider contacting the lender and working out a payment plan that suits you. Early planning helps you to be realistic and get a favorable payment plan since late payments of a personal loan can severely affect your score.
How Loan Balances Affect Your Credit Score
The remaining balance of your outstanding loan can also influence your score. You gain points when you continue to pay your installments, hence reducing your loan amount.
Your credit score goes up whenever you keep reducing the amount of money you owe to your lender.
It’s essential to ensure that you properly manage your loans. These loans can be beneficial when they are well utilized. Taking a personal debt is something you should not take lightly or without considering your current financial position.
It’s good to check your credit standing first before taking a personal loan. A failure to pay the loan on time could negatively affect your credit score.