Have you ever found yourself in a situation where you need money urgently but don't have enough savings to cover the expenses?
Maybe it's a medical emergency, a home renovation project, or a sudden job loss. Whatever the reason, personal loans can be a lifesaver in such situations. However, before applying for a personal loan, you might wonder how it will affect your credit score. Will it help or hurt your creditworthiness?
In this blog post, we'll explore the relationship between personal loans and credit scores to help you make an informed decision.
Understanding Credit Scores
To understand the relationship between personal loans and credit scores, we first need to understand what a credit score is and how it's calculated.
The most commonly used credit score is the FICO score, which ranges from 300 to 850. The FICO score is calculated based on five factors:
- Payment history:Your track record of paying bills on time.
- Credit utilisation:The amount of credit you're using compared to your credit limit.
- Length of credit history:The age of your credit accounts and how long you've had credit.
- Credit mix:The types of credit you have, such as credit cards, loans, and mortgages.
- New credit:The number of new credit accounts you've opened recently.
Now that we understand how credit scores are calculated let's explore how personal loans can affect them.
How Personal Loans Affect Credit Scores
When you apply for a personal loan, the lender will conduct a hard inquiry on your credit report. A hard inquiry is when a lender checks your credit report to evaluate your creditworthiness. A hard inquiry can lower your credit score by a few points temporarily. However, the impact is usually minimal and fades away within a few months.
If you get approved for a personal loan, it can have a positive impact on your credit score. One factor that affects your credit score is credit utilisation, which is the amount of credit you're using compared to your credit limit. Personal loans are instalment loans, meaning you borrow a fixed amount of money and repay it in fixed monthly payments over a set period, usually two to five years. Unlike credit cards, which are revolving loans, personal loans have a fixed repayment term, which means you can't add to the balance like you can with a credit card. Paying off a personal loan on time can improve your credit utilisation ratio and boost your credit score.
When Not to Apply for a Personal Loan
While personal loans can positively impact your credit score, there are some instances when you shouldn't apply for one. Personal loans come with interest rates and fees, which can add to your debt burden. Moreover, if you don't have a stable income source or a good credit score, you may not qualify for a personal loan or may get approved at a high-interest rate, which can make it challenging to repay the loan.
Personal loans can be a useful financial tool to cover unexpected expenses or consolidate debt. Consider your credit score, income, debt-to-income ratio, and future loan needs. By making an informed decision, you can use personal loans to your advantage and achieve your financial goals.