The personal loan application process can 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 image.
How loan applications impact your credit
When you apply for a personal loan, lenders assess your credit rating and history to determine your credit risk or creditworthiness. To do this, they will perform a rigorous credit check. When performing this check, they look for indicators of financial health, such as low credit balances and a good debt-to-income ratio. Whether or not you are financially healthy, you will likely see some points lose your credit score as a result of the thorough check.
If you are applying for a personal loan, you probably cannot avoid a thorough credit check. However, investing in a long-term personal loan can be worth it compared to the few points you might lose.
Can Personal Loans Help Your Credit?
Under the right circumstances and when used responsibly, a personal loan can absolutely improve your credit health. Here are some ways a personal loan can have a positive effect on your credit rating:
- Debt Consolidation: If you use a personal loan to consolidate your debt, you can usually take advantage of lower interest rates than you would get with credit cards. With a lower interest rate, you may be able to pay off your unpaid debts 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 constitutes 35 percent of your FICO score, the most important category to determine your score.
Can personal loans hurt your credit?
While personal loans can improve your credit score, they can also hurt your score if you are not ready to pay them back. Here are some risks you should consider before applying for a personal loan:
- Serious investigation of your credit: Due to the credit check, you will likely see a short-term drop in your credit score when you officially apply for the loan. While this won’t hurt your long-term credit score, it could hurt 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 with a considerably high interest rate and fees. The higher the interest rate, the longer it takes to repay the loan, and if you can’t afford those long-term rates, you risk falling behind on your payments and damaging your credit score.
- Get into more debt: Every time you apply for a loan, you are borrowing money, which can put you in further debt, especially if you continue to accumulate credit card balances while paying off your loan. While not all debt is negative, it’s important to do an analysis of your current financial situation before applying to determine if a loan is a step in the right direction.
What to consider before taking out a personal loan
Before taking out a loan, think about the pros and cons of adding another monthly bill to your budget. Here are a few things to consider:
- Why you are taking the loan: Are you interested in a personal loan to pay for a vacation or a luxury item? If so, consider whether it makes more sense to save for the item than to apply for a loan. Depending on the interest rate, you could pay for this vacation for a period of time, and you will pay extra in the form of interest.
- Your credit rating and history: Do you have a good credit score and healthy habits with your credit? If not, there are steps you can take to improve your credit score by putting aside some of these bad habits.
- Your debt-to-income ratio: Your debt-to-income ratio, or DTI, measures the amount of your monthly debt compared 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 your options: Finding the best personal loan for you is one of the most important steps to take. Each lender offers different rates, fees and terms. The best way to find out how much you would pay each 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 your credit card debt, or pay off your medical bills. However, it is important to know how applying for a loan can affect your credit score. While you may experience a short-term drop when you submit your application, you could potentially improve your long-term credit score by making timely payments and using your loan funds to pay off existing debt.
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