Sometimes, life throws us curveballs, and we need cash to take care of them. Whether it’s an unexpected car repair, a tuition bill or some other emergency, a personal loan can give you the financial boost you need to meet your needs. Like any other type of loan, a personal loan has to be repaid, and opening the account does affect your credit.
Applying for a personal loan can negatively affect your credit score since it adds an inquiry to your credit report. Taking out the loan can also hurt your score by increasing your debt-to-income ratio; however, making regular payments on the loan can help improve your score over time.
Credit Score Calculation
A credit score is a snapshot of the information in your credit report. A common type of credit score is the FICO score, named for the Fair Isaac Corporation that developed it. Credit bureaus calculate the score based on the amount of money you owe, your payment history, the length of your credit history, how much new credit your have and the types of credit you have. Each category is weighted – your payment history and the amount you owe influence your score more than the number of new accounts you have. Your score changes over time based on how you use credit.
Applying for the Personal Loan
When you apply for a personal loan, the lender will most likely check your credit by reviewing a credit report from one of the three major credit bureaus, Equifax, Experian and TransUnion. The credit bureau then adds that credit check to the report as an inquiry, which generally lowers your credit score by a few points. A credit inquiry only reduces the overall score by a few points for most people, according to the MyFICO website, run by the agency that calculates credit scores. However, if you already have a poor credit score, a short credit history or only a few accounts, the overall effect on your credit score will be greater.
Taking a Personal Loan
While applying for a personal loan has a small effect on your credit score, if you accept the loan, the amount you borrow and your payment history on the account will have a greater impact on the overall score. Taking out a personal loan increases the amount of money you owe and changes your overall debt-to-income ratio. The greater that ratio, the lower your score and the less likely you are to get new credit. Repaying the loan on time and according to the terms of the lender prevents you from losing more points on your credit score and in time will help you add points due to your excellent payment history.
Making Multiple Inquiries
When it comes to your credit score, applying for a personal loan is different than applying for mortgages, auto loans or student loans. Many people apply for home, auto or school loans from multiple companies so they can compare loan rates. This practice of rate shopping does not generally affect your credit score, as FICO treats multiple inquiries of the same type that occur within 30 days as one inquiry. This does not apply to personal loans, though. If you are comparing personal loan interest rates and terms, get the information before you apply for the loan instead of applying for multiple loans. You’ll lose points on your score with each application and inquiry.
An adjunct instructor at Central Maine Community College, Kristen Hamlin is also a freelance writer on topics including lifestyle, education, and business. She is the author of Graduate! Everything You Need to Succeed After College (Capital Books), and her work has appeared in Lewiston Auburn Magazine, Young Money, USA Today and a variety of online outlets. She has a B.A. in Communication from Stonehill College, and a Master of Liberal Studies in Creative Writing from the University of Denver.