As with all financial information that appears on a consumer credit report, a personal loan will be calculated into your credit scores. Whether the loan will result in higher or lower scores, however, depends on a variety of factors.
Generally, opening a personal loan will help your credit score if you maintain it responsibly with on-time payments. But your credit rating could dip slightly when a lender checks your credit or if the new account lowers the average age of your accounts. And if you don’t pay as agreed, a personal loan can quickly become a problem for your credit score.
What Are Personal Loans?
A personal loan is a fixed amount of money borrowed from a financial institution, such as a bank or a credit union. It’s a closed-end credit product, which means you can’t add to the balance after it’s been granted.
Unlike secured loans that you would use to finance a vehicle or home, where the asset acts as collateral, personal loans are usually unsecured. As such, they are granted based primarily on your creditworthiness. Personal loans are commonly used to consolidate credit card debt, cover the cost of medical bills or pay for things such as a vacation or large purchases.
As with other types of loans, you are expected to repay the debt in full by a set date. The lender sets the installment payments so you will eliminate the balance by the term’s end, and finance charges are embedded into the payment. If you stick to the payment schedule, your balance will decline over time.
Read: [Best Personal Loans.]
How Personal Loans Appear on Credit Reports
For a personal loan to be calculated into your credit scores, it must be listed on your consumer credit reports. When you obtain the loan from a financial institution, it should be recorded on your reports. Loans from friends and family members can’t affect your credit scores because individuals aren’t authorized to furnish information to the credit reporting agencies.
If you get the loan from a lender that supplies data to the credit bureaus, the date it checked your credit will be listed in the inquiries section of the reports. After you open the account, it will appear on your credit reports, including the opening date, remaining balance and payment history.
All of the data about your personal loan is relevant because the information is used to calculate your score, which predicts credit risk. How will adding a personal loan to a credit report impact your score? Because the algorithms for credit scoring are proprietary, you can’t know for sure until you take out the loan. Still, there are general rules about personal loans and credit scoring that you can follow.
Personal Loans and FICO Scores
“There is no universal guideline on how personal loans will affect a credit score,” says Tommy Lee, principal scientist at FICO. “It depends on how the consumer uses credit overall and over time.” There are five factors that make up a FICO score, and, says Lee, a personal loan can affect each of them.
Payment history (35 percent). How you handle your loan payments is vital to your score. All recorded payments are factored in, but, says Lee, those you make on installment loans take a bit more precedence than those for credit cards.
Amount owed (30 percent). The total of your financial obligations, as well as the percentage of available credit being used is important. For personal loans, the original amount you borrowed is compared with the current balance. As the loan balance declines, your score should rise.
Length of credit history (15 percent). The date you opened your oldest account influences your credit score, along with the average age of your accounts and the time frame since your most recent payment. Your score should rise as the loan ages, assuming you pay as agreed.
Credit mix (10 percent). This is your credit portfolio, and you will be assessed on the variety of credit products you have. Adding a personal loan to your mix of accounts (such as credit cards, retail accounts, finance company accounts, and mortgage and vehicle loans) can enhance your credit.
New credit (10 percent). Applying for and obtaining new credit accounts, including loans, can affect your score in a negative way, and a loan that you recently applied for can shave off a few points. A single inquiry can lower a score by five or fewer points, but multiple inquiries that fall in a typical loan shopping period of 30 days are counted as just one.
Given this basic overview of how FICO scores are generated, says Lee, you can make sure a personal loan will positively impact your score by making all payments on time, steadily reducing the balance, incorporating personal loans into your credit portfolio and keeping your loan applications to a minimum.
Read: [Debt Consolidation Loans.]
How Personal Loans Affect VantageScores
The other major credit scoring system is the VantageScore, and it uses a different system from FICO to describe how the scores are calculated:
— Extremely influential: payment history.
— Highly influential: age and credit type, as well as percent of credit used.
— Moderately influential: total amount of recently reported balances.
— Less influential: number of recently opened credit accounts and credit inquiries.
Personal loans affect the span of categories, says Jeff Richardson, vice president of communications and public relations for VantageScore Solutions. For example, “a new loan might reduce a score by five or 10 points over the course of three months, but it will be a temporary reduction as long as you don’t miss payments.”
The VantageScore calculates credit card and personal loans differently. There is no credit utilization factor for a loan, so your score doesn’t depend on the balance compared with the original loan amount. But the amount you owe will be added to your total debt category. Less debt is preferable, so your VantageScore will rise as the personal loan balance declines.
Additionally, says Richardson, VantageScore’s 4.0 model assesses your payment history in detail. The occasional higher loan payment won’t matter much to your score, but if you consistently send more than the minimum, your scores will climb faster. “We reward you for that kind of behavior,” he says.
Regarding the initial loan inquiry, the VantageScore model won’t downgrade you for shopping around for the best loan, as long as you do it within a short period of time. Multiple loan inquiries made within two weeks are considered a single inquiry.
Read: [Bad Credit Loans.]
Personal Loans Affect People With Thin and Thick Credit Files
Clearly, the way you handle a personal loan is instrumental to the movement of your credit scores, no matter which company is calculating them. But where your credit history started out is also a factor.
“Personal loans will have a greater impact on your score if you have a thin credit file versus a thick credit file,” says Lee. That’s not a reason to run out and apply for a new loan without making sure you can manage it, though.
“We would not suggest opening a loan simply for the sake of a score,” he says. “You have to afford the debt you take on. If you miss payments, it will have a very negative impact.” According to Lee, even one missed payment will shave off 60 to 100 points from your FICO score.
The message from Richardson concerning VantageScores and thin files is similar. “It’s positive to take out a loan if you don’t have credit history,” he says. “You can move from a thin- to a thick-file consumer this way. The more you have on your reports, the better, but you should never take out a loan when you can’t meet the payments or when it will affect your other credit payments.”
Conversely, says Lee, if you already have an established credit history, you might experience a slight decline in your score when you first take out a personal loan. “It will impact the length of credit history aspect of the FICO score, then lower the average age of your accounts,” he says. “In the long run, it will be positive for the score, but the opening of a personal loan can negatively affect your score because it’s new. It evens out after a while, though.”
So can you develop a high credit score by relying heavily or entirely on personal loans? Yes, says Lee, “but it’s still better to have a mix of credit types.” Begin with the personal loan or add one to accounts you’ve had and used for years. The result will be advantageous if you handle it strategically. Just try not to fixate on deciphering the exact scoring impact it will have.
“There is no ideal mix of loans and other accounts,” says Lee. “The fact is, there are many paths to a high score.”
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Do Personal Loans Help or Hurt Your Credit Score? originally appeared on usnews.com
