Sometimes life tosses us curveballs. Financially, those can appear in the form of unexpected medical bills, sudden car troubles, home appliance repair or replacement.
While an emergency fund is designed to cover those unforeseen events, the majority of Americans, unfortunately, can’t cover a $1,000 emergency expense.
One option to fund a major purchase when you don’t have the cash on hand is to take out a personal loan.
However, as with any loan or a line of credit, your credit score may be affected in more than one way. That’s why it’s important to understand the risks as well as the benefits.
Keep reading to learn more about personal loans and their effect on your credit score.
What Is A Credit Score?
A credit score is a three-digit number intended to represent your credit risk and the general likelihood that you will pay your bills on time.
Your lender or creditor will typically report your information to the three main credit bureaus (Equifax, Experian and TransUnion) at least once a month.
Credit scores range from 300 and 850. Here is an example of credit score ranges and the designation:
| Standing | Range |
|---|---|
| Poor | 300-579 |
| Fair | 580-669 |
| Good | 670-739 |
| Very Good | 740-799 |
| Excellent | 800-850 |
What Determines Credit Score?
Once your information has been reported to the credit bureaus, they’ll use one of the various predictive scoring models to calculate your score. While numerous scoring models are available for the bureaus, they generally use either FICO or VantageScore.
FICO and VantageScore typically use the same data to calculate your score. However, the importance of one factor may influence the score more than others.
FICO uses five elements when calculating your score. Here are the factors they consider and how important each one is to determine your overall score.
- Payment history (35%)
- Amounts owed (30%)
- Length of credit history (15%)
- Credit mix (10%)
- New Credit (10%)
On the other hand, VantageScore uses six factors when determining your credit score. Keep in mind that the importance of factors will vary slightly from the FICO calculation.
- Payment history (40%)
- Age and credit type (21%)
- Credit Utilization (20%)
- Total balances and debt (11%)
- Recent credit behavior and inquiries (5%)
- Available credit (3%)
When you look at your credit score through Credit Karma, you’ll be looking at your VantageScore. But when you look at your credit score via your credit credit or bank, you may be looking at your FICO score.
It’s important to understand how each factor affects your credit score and why you may see discrepancies between the two scores.
What Is A Personal Loan?
Unlike student loans or mortgage loans, which are intended for specific purposes, personal loans can be used to fund almost anything you desire. For example, you may take out a personal loan to consolidate debt, cover an emergency expense or help start a new business venture.
Personal loans are unsecured loans, meaning you aren’t required to put up any collateral to receive the loan. As a result, personal loans generally carry higher interest rates than secured loans such as auto or home loans.
However, personal loans typically come with less interest than credit cards.
According to Experian—one of the three main credit bureaus, the average personal loan interest rate in Q2 in 2019 was 9.41%.
Compared to the national average for credit cards, which is 16.17% as of March 2022, according to creditcards.com.
The interest rate on a personal loan may vary depending on your credit score. While each lender may have different credit score minimums to qualify for a personal loan, generally, you’ll need a score of 670-739.
Do Personal Loans Help Your Credit?
Like any other form of credit, if you use personal loans properly, you can help build your credit. Let’s delve into some of the ways personal can boost your credit score.
- Helps establish a well-rounded credit mix: FICO and VantageScore consider credit mix to be approximately 10% of your overall calculation. Having different types of credit in your profile can boost your credit score. Personal loans are considered installment loans (pay off in monthly installments). If the majority of your credit is revolving credit, such as credit cards, adding a personal loan will strengthen your credit mix.
- Builds up payment history: Payment history is the most significant factor in calculating your score. If you take out a personal loan and make consistent on-time payments, you’ll notice an increase in your credit score.
- Reduces your overall credit utilization ratio: Credit utilization ratio is another major factor when determining your score. Since personal loans are installment loans, they don’t factor into your CUR. However, if you use a personal loan to pay off revolving credit, you can improve your score by replacing the revolving credit.
Does A Personal Loan Hurt Your Credit Score?
Personal loans do come with some drawbacks as well. Before you consider taking out a personal loan, you should see if the benefits outweigh the disadvantages.
- A hard inquiry will be initiated: The lender will pull your credit history when you apply for a loan or new line of credit. As a result, your credit score is affected negatively. Hard inquiries only drop your score by a few points and generally only show up for a few months after it was initiated.
- Additional fees: On top of the interest you’ll need to pay on a personal loan, you may get hit with origination of late fees (if payment is not received on time). Before you apply, it’s important to understand all the fees associated with the loan.
- Drive yourself further into debt: When you take out a personal loan, you are signing up for more debt. You should evaluate your current financial situation to see if you can shoulder the extra debt payment.
Secure A Personal Loan With Arizona Central Credit Union
Personal loans can be a great way to fund major expenses. If used properly, you can boost your credit score. But you’ll need to consider some of the disadvantages before applying.
If you feel the benefits heavily outweigh the drawbacks, Arizona Central Credit Union offers You-Name-It Personal Loan™ for up to $15,000. Apply online or contact us for additional information.
