Personal loans can be used to pay for pretty much anything you want. Whether you just need a quick cash infusion, have to make an unexpected purchase or need to bridge a financial gap, you may be considering taking out a personal loan. These loans are often unsecured, which means those without anything to put up for collateral may still be able to get approval.
Prospective borrowers looking to use a personal loan typically have a lot of questions. What effect is a personal loan going to have on my credit score? Will a personal loan raise my credit score? Can a personal loan hurt my credit score? As FICO is expected to adopt an updated credit score scoring system this year, the effects of a personal loan on your report are expected to increase your credit score.
Here’s how a personal loan could improve your credit score
Your credit score is a numerical representation of your creditworthiness. It’s designed to help lenders and financial institutions better understand your history of making good on your debts. Lenders and financial institutions use this snapshot to make decisions about what they will and will not let you do in the future.
A low credit score is not just the result of missed payments or negative credit history. Your score can also be low because you have no borrowing history for the credit bureaus to go off of. For people in this category, a personal loan may help to raise their score in the long run. By taking out a loan and demonstrating that you can fulfill your obligations to make on-time payments, you’ll start to build a positive credit history.
For those that have a negative borrowing history riddled with missed and late payments, personal loans can also help. By demonstrating that you’ve changed your ways and are now ready to make good on your financial obligations, you can start to erase your negative past and raise your credit score.
“Paying bills on time each and every month can have one of the biggest impacts on a credit score, and this includes personal loan payments,” says Amanda Wallace, head of insurance operations for MassMutual. “When times are tight, if there is nothing else you do, just pay on time. ”
While you could be better served to demonstrate your creditworthiness through a different borrowing mechanism, personal loans can still help to build the positive track record necessary for a higher score.
And here’s how it could hurt your credit score instead
Unfortunately, there’s a lengthy list of ways a personal loan can hurt your credit score. Some of these negative effects are only in the short term, while many could stick with you and your credit profile for several years.
Recently, the Fair Isaac Corporation (FICO) that’s responsible for creating the FICO credit score announced a rollout of changes coming to the credit scoring system in 2020. While the changes may not be adopted immediately, they’re coming, and they will affect how personal loans are viewed by credit bureaus. The company states people who take out personal loans will be flagged, as personal loans are a much riskier form of borrowing. Even with this, making your payments on time and fulfilling your loan obligations should still have a long-term positive effect on your overall credit score under the new system.
Credit bureaus view too many inquiries into your credit as a negative. Think of it this way. If one friend asks you for money one time in a year and another friend asks you for money five times a week, which friend seems riskier to lend to? This is how credit bureaus tend to view credit inquiries like the ones required to secure a personal loan.
Taking out a personal loan also increases the amount of outstanding debt you have. It’s believed that around 30% of your credit score is based upon the amount of debt you have outstanding. The more debt you have, the lower your score.
Many of these negative factors, though, would only be short term if you make on-time payments and fulfill your credit obligations. Your credit score could take a nasty hit, though, if you start to miss payments or make late payments. As of the current system, late payments stay on your credit report for seven years. The new FICO system is looking to analyze a longer period of your credit history, which could make these missed and late payments even worse.
As personal loans are typically unsecured, they also typically carry higher interest rates and annual percentage rates (APR). In other words, the money is more expensive, which means your payments will be either larger or last for longer than with other sources of borrowing. These two factors increase the risk of missing a payment, which, in turn, increases your risk of hurting your credit score. If your credit score is already less than perfect, a bad credit loan may be worth considering.
The reason FICO is changing its scoring metrics is that personal loans are a much riskier form of borrowing. Because they rarely require collateral and often have higher interest rates, they can be a potential red flag of a riskier borrower. However, when used properly, personal loans can help in times of need when you have no other options for getting access to the cash you need. Additionally, they have the ability to help borrowers demonstrate and build a history of on-time payments.
But with these benefits do come the potential risks to your credit score. Both short term and long-term risks need to be weighed and considered before deciding to move forward with a personal loan.