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You've been hit with an unexpected medical expense. Your credit card balance has gotten seriously out of hand. The plumber just gave you an estimate that's bigger than your kid's college tuition bill. Could taking on more debt be the solution to these problems?
Possibly, if that debt is a personal loan. A personal loan can give you a way to pay for major expenses when you don't have the cash on hand. However, a personal loan may impact your credit score either positively or negatively, so it's important to know the risks and benefits before you apply for one. Keep reading to find out how a personal loan might affect your credit score and whether it's the right choice for you.
What Is a Personal Loan?
Unlike auto or home mortgage loans, which are designed for specific purposes, personal loans are consumer loans that can be used for just about anything you want. For instance, you might take out a personal loan to help you start a new business, pay your medical bills or finance an expensive but urgent home repair (such as a new roof in the middle of the rainy season).
Because personal loans generally have lower interest rates than credit cards, many people use them to pay off credit card debt or other high interest debt. (These loans are sometimes advertised as debt consolidation loans.) However, since personal loans are unsecured—meaning they don't require you to put up any collateral—their interest rates are higher than those for secured loans such as auto loans or home mortgages.
You can get a personal loan from a bank, credit union or online lender. The loan terms you qualify for will vary depending on your credit score, the amount you're seeking and other factors. As long as you have a good credit score, you can often get approved for a personal loan within days. Find out what else you should know before you apply for a personal loan.
How a Personal Loan Can Help Your Credit
Depending on how you use them, personal loans can help to improve your credit score in several ways.
- Contributing to a better credit mix: Having a variety of different types of credit helps to boost your credit score. A personal loan is an installment loan (meaning you pay it off in regular monthly installments). If most of your credit is revolving credit, such as credit cards, a personal loan can enhance your credit mix.
- Helping you build a payment history: Making your personal loan payments on time helps to establish a positive payment history, which can increase your credit score. (The key is to be sure you can make the loan payments in full and on time every month.)
- Reducing your credit utilization ratio: Because it's an installment loan, a personal loan doesn't factor into your credit utilization ratio, which measures how much of your available revolving credit you're using. Using a personal loan to pay off revolving credit, such as credit card debt, can help you improve your credit scores by replacing revolving debt (which factors into your credit utilization ratio) with an installment loan (which doesn't).
How Personal Loans Can Hurt Your Credit
Ready to fill out that personal loan application? Not so fast. Personal loans also have some downsides you should be aware of.
- Creating an inquiry on your credit report: When you apply for any type of credit, including a personal loan, lenders will do a credit check on you. This results in a hard inquiry on your credit report, which negatively affects your credit score. The dip from a single hard inquiry lasts only a few months; however, too many hard inquiries can do more damage to your credit score. If you're applying for personal loans from multiple lenders to get the best terms, consolidate your applications into the span of a week or two to minimize their negative impact on your credit score, since credit scoring models view this as rate shopping and don't ding your credit for it.
- Getting you deeper in debt: Taking out a new personal loan means taking on more debt. If you use the personal loan to pay off higher interest debt, it's important to make sure you also change the habits that got you into debt in the first place. For instance, if you use a personal loan to pay off a maxed-out credit card, and then start charging more than you can afford on that card again, you could easily end up with a maxed-out credit card ... plus a personal loan to pay off.
- Additional fees: In addition to the interest you'll pay on a personal loan, don't forget about loan costs such as origination fees or late fees. Make sure you understand all of the fees involved before you apply. If necessary, consider borrowing enough to cover the fees.
When to Consider Taking Out a Personal Loan
Now that you know the pros and cons of personal loans, when might it make sense to apply for one? Here are some scenarios where a personal loan could be your best option.
- You need to pay off high interest debt. Since they have lower interest rates than credit cards, personal loans can help you get out of credit card debt at a lower cost.
- You have a costly emergency. Sure, you could put that new roof on a credit card—but then you're taking on high interest debt that will grow over time. When an expensive emergency strikes, a personal loan with its lower interest rate and fixed payments can be a better way to go.
- You want to remodel your home. Unlike a home equity line of credit (HELOC), personal loans don't require using your home as collateral. This allows you to finance remodeling without putting your home at risk.
Some people take out personal loans to finance weddings, vacations and other big events. Whether or not this makes sense for you depends on your personal finances. If you know you'll have the money to make the loan payment every month, a personal loan could be the answer you're looking for. But if you're already living on a tight budget, taking out a personal loan to finance a trip to Fiji could get you in trouble. If you can't make the payments, your credit score will suffer. Instead, start socking away money to save for the trip of your dreams rather than paying extra in interest to fund it. Find out more about when to take out a personal loan.
Personal loans can be a useful tool for improving your credit score, reducing credit card debt or covering unexpected expenses. However, they also come with costs and risks that you need to consider before you apply. Carefully weigh the pros and cons of personal loans and take an honest look at your own financial behavior to decide if a personal loan is right for you.