There are many things to consider before getting a personal loan, including how it will impact your credit. Depending on your credit profile, a personal loan may help your credit and your credit scores, especially if you are using the loan to pay down existing, higher-interest rate debt. A personal loan can also make it easier to follow the golden rule of credit—paying your bills on time every month—because it can reduce the outflow of monthly payments.
But just like any new credit account, making your payment on time every month is critical to maintaining good credit scores. The key is to manage your personal loan experience so it impacts your credit in all the positive ways, and none of the negative ways—and reap the credit-boosting benefits of doing so.
What Is a Personal Loan?
A personal loan is a form of credit—usually issued by banks, credit unions, or digital lenders—that can help you make a big purchase, start a small business, or bundle high-interest debt into one, easier-to-manage, lower-interest debt payment. As personal loans typically have lower interest rates than credit cards, they can be also used to consolidate multiple credit card debts into a single, lower-cost monthly payment.
While credit can be a robust financial tool, signing off on a personal loan of loan is a serious obligation. Thus, before you decide to apply for a personal loan, thoroughly measure the pros and cons that can affect your unique credit scenario.
The Credit Score Advantages of Getting a Personal Loan
1. It Lowers Your Credit Utilization Ratio
A personal loan is an installment loan, so the debt is not considered in your credit utilization ratio, which is a calculation of all revolving debt compared with how much credit you have available to you. If you pay off revolving debt with a personal loan, it will lower your utilization ratio, which can have a positive effect on your credit scores.
2. It Adds Variety to Your Credit Type
According to FICO®, there are five factors that determine your credit score: Payment history, credit utilization ratio, length of credit history, new credit inquiries and credit mix."
While credit mix only counts for 10% of your credit score, a personal loan can help by creating a more varied mix of credit types, which lenders and creditors tend to view favorably," says Chelsea Hudson, a personal finance expert at TopCashback.com.
3. You Will Establish a Payment History
In the long run, a personal loan could help your credit scores as long as you make your payments on time and in full. "The more on-time payments you have, the better your credit score," Hudson adds.
4. Debt Consolidation
Paying down balances on credit cards by bundling them into one, the lower-interest-rate loan is known as debt consolidation and can help boost your credit scores.
"The upside of getting a personal loan is that most people will use the personal loan to pay down their credit card balances," says Irene Prewitt, CEO of Hannah Financial in Cleveland, Ohio and a certified credit specialist. "This will save the consumer money in the long run because the interest rate on the personal loan is usually a lot lower than the interest rates that credit cards carry."
The Disadvantages of Getting a Personal Loan
1. Additional Inquiries on Your Credit Report
When you apply for a personal loan, the lender performs a credit check to gauge your creditworthiness. "A personal loan will appear as a hard inquiry on your credit report, which will impact your credit score," Hudson says.
2. Additional Debt
While a personal loan could simplify debt repayment and help you reach your financial goals faster, only borrow what you need so you don't increase the amount you owe.
Look out for any origination and late fees. "More often than not, most loans charge an origination fee that cannot be avoided and is automatically deducted from your loan amount," Hudson says. "If you need a $10,000 loan, for example, and there is a 3% origination fee, then make sure you borrow $10,309.28 to cover the fee and still get the $10,000 you need. Like most loans, any late payments can result in expensive late or overdraft fees. To prevent any unnecessary late fees, ensure you pay the minimum payment on time each month.
Lowering Interest Rates for Existing Debt
One way to avoid having to take out a personal loan, and thus potentially incur negative credit outcomes, is to negotiate your debts down to a more manageable payback scenario.
"Before deciding if you need a personal loan if you're in financial trouble, try contacting your creditors to work out a payment plan," says Gary Scheer, a financial planner with Retirement Financial Advisors, LLC, in Morristown, N.J. "Just be realistic about the payments because missing payments will negatively impact your credit.
Weigh Your Credit Score Risk Before Taking out a Personal Loan
Taking out a personal loan may be a good idea if you're using the cash to pay down or consolidate debt at a lower interest rate or make certain types of large purchases, such as a home remodel or wedding.
Before you sign off on any personal loans, though, conduct a thorough analysis of your overall debt situation, the terms of the loan and whether you can afford the monthly loan payment.
Do that and pay down your loan on time, and you'll hike your odds of having a quality personal loan experience while keeping your credit scores out of harm's way.
Editorial Disclaimer: Opinions expressed here are author's alone, not those of any bank, credit card issuer or other company, and have not been reviewed, approved or otherwise endorsed by any of these entities. All information, including rates and fees, are accurate as of the date of publication.
This article was originally published on September 13, 2018, and has been updated.