You may have heard that when you apply for a loan, your credit score takes a hit. But is that true? And if it is, how long does the damage last? In this article, we’ll take a closer look at what happens when you apply for a loan and whether or not it hurts your credit score.
Loans are a great way to get what you need. But it’s important to know the impacts personal loans may have on your credit score. You could experience a drop in your credit score when you first apply for a personal loan since some lenders conduct hard credit checks before finalizing a loan.
On the other hand, making regular, on-time payments on a personal loan can improve your credit score in the long run. It would be best to weigh all the factors before deciding whether to take out a personal loan and how it will impact your credit.
How loan applications affect your credit
If you apply for a personal loan, lenders will determine whether you are creditworthy or at risk based on your credit history and score. Lenders will run a credit check on you to determine this. These checks look for financial health indicators, such as low credit balances and an affordable debt-to-income ratio. You are likely to see a few points knocked off your credit score due to a hard inquiry, regardless of your financial standing.
A higher credit score means you will have a better chance of being approved for a personal loan – and at a lower interest rate.
How Can a Personal Loan Help Your Credit Scores?
Personal loans reported to credit reporting agencies can help your credit score. Be aware that it’s not just the loan itself that makes a difference, but also how you handle it.
Taking out a personal loan can positively impact your credit scores in the following ways. However, many other factors affect your credit scores as well. To maintain good credit scores, you will need to monitor them all.
Making payments on time every month could help you build a positive payment history. And according to the CFPB, Consumer Financial Protection Bureau, a good payment history could help you improve your credit scores or maintain good credit scores.
Setting up a budget or automatic payments will make it easier to stay on top of your bill payments.
If you consolidate your debt with a personal loan, you’re likely to receive lower interest rates than if you used a credit card. Your credit score will increase if you can pay off outstanding debt faster due to the lower interest rate.
Providing a better credit mix
Your credit score is boosted by having various types of credit. An installment loan (meaning you pay it off in regular monthly installments) is what we call a personal loan. A personal loan can improve your credit mix if most of your credit is revolving credit, such as credit cards.
Decreasing your credit utilization ratio:
A personal loan does not affect your credit utilization ratio, which calculates how much of your available credit you’re using. Paying off revolving credit, such as credit card debt, with a personal loan and replacing it with an installment loan, which does not factor into your credit utilization ratio, can enhance your credit score.
How do personal loans affect your credit?
You may improve your credit score with personal loans, but they can also negatively affect it if you are not prepared to pay them off. You should be aware of the following risks before applying for a personal loan.
Potential high-interest rates and fees
You may end up paying high-interest rates and fees if you’re not creditworthy. Getting a loan with a high-interest rate may take a longer time to repay. If you don’t have the money to afford high rates in the long term, you risk defaulting on payments and damaging your credit score.
A Hard inquiry on your credit
Your credit score is likely to drop in the short term when you formally apply for the loan due to a hard credit check. Although this is unlikely to harm your long-term credit score, you could damage your credit if you apply for multiple loans in a short time.
Borrowing money increases your chances of falling into debt, especially if you continue to accumulate credit card debt while paying off your loan. A loan is not necessarily a bad thing. But it’s important to assess your financial situation before applying to determine if it’s the right decision.
What to consider before taking out a personal loan
Before taking out a personal loan, you should carefully consider your options. You should think about why you’d like to take out a personal loan and if the benefits outweigh the potential disadvantages.
- Why are you applying for a personal loan?
Do you want to borrow money for a vacation or a high-ticket item? If the interest rate is high while you’re paying off your vacation or luxury item, you may have to pay extra in interest in the long term. In this case, rather than applying for a loan, you might want to consider saving the money.
- What is your debt-to-income ratio?
Your Debt-to-income Ratio is the amount of your monthly debt compared to what you make in income. Generally speaking, the higher this number, it makes getting a loan more difficult. If your debt-to-income ratio is high, try to increase the amount you pay monthly toward your current debts before taking out a personal loan.
- What are all of your personal loan options?
When you’re in the market for a personal loan, lenders offer many different rates and terms. To ensure you have a manageable and affordable monthly payment, it’s important to shop around for the best personal loan.
Choosing a Personal Loan
Taking out a loan can be a useful way to improve your credit score, consolidate credit card debt, or pay off major expenses. In any case, it’s important to understand how applying for a loan could impact your credit score. Making timely payments and using your loan funds to repay existing debt can improve your credit score over the long run, even if you experience a short-term dip when you submit your application.