When used responsibly, personal loans can help you build and maintain a good credit score. There are several factors that go into determining your credit score, and making payments on a personal loan can contribute to a few of them.
However, before you apply for a personal loan, it’s also important to consider the potential drawbacks. Here’s everything you need to know
How can a personal loan help improve my credit rating?
Personal loans are among the most versatile forms of credit, as you can use them for just about anything you might need. How? Not all loans help improve your credit report; first, your loan payments must be reported to the national credit bureaus (in Canada: TransUnion and Equifax). If you make your repayment on time; the positive payment history associated with the loan will help improve your credit. However, taking out a personal loan can do more harm than good, so be careful with your borrowing and stay within your budget.
There are several ways to calculate your credit score, but most use five main factors to determine the health of your credit. Among these, here are the three indicators that can be positively influenced by a personal loan, a micro loan or other loans (mortgage, car, etc.):
- Payment history : Your payment history is the most important indicator of responsible credit use and is usually the most important weight in credit calculations. By making timely and regular payments on your loan, you will establish a positive payment history and potentially improve your credit score. Banks and private lenders are generally inclined not to report a default if the situation is corrected quickly. To prevent your loan from hurting your goal, be sure to contact your lender and negotiate your options with them.
- Amounts owed: Using a personal loan to consolidate credit card debt can significantly improve your credit if it helps you reduce your credit utilization ratio. You can calculate your credit utilization ratio by dividing your credit card balances by their limits. For example, a $1,000 balance on a card with a $2,000 limit has a 50% utilization rate. By paying off the card with a personal loan, you reduce that percentage to 0%, which can help boost your credit score. The amount of debt you owe will still maintain an impact on your score, but not as much as a high credit utilization rate.
- Credit mix: Your credit score also takes into account how you manage different types of credit. For example, someone who has credit cards, student loans, a car loan and a mortgage may be viewed better by lenders than someone who has only ever had credit cards, even if both use their credit responsibly. Adding a personal loan to your credit report can strengthen your credit mix and improve your credit score. What the industry is assessing with this score is your familiarity with the borrowing and repayment process. Using multiple financial products shows that you are familiar with these transactions and therefore increases the confidence of banks and lenders.
Ways a personal loan can hurt your credit
While there are obvious advantages to using a personal loan to establish credit, there are potential pitfalls that are easy to avoid when you recognize them:
Missed payments : Taking on debt that you can’t afford to pay back can significantly hurt your credit score. Consider applying for a personal loan only if you are confident you can afford to make your monthly payments on time for the entire loan repayment period. This is the most common mistake made by first-time borrowers; be vigilant and know your repayment capabilities, as the penalties associated with defaulting on payments can quickly become a financial burden.
Credit Inquiry: When you apply for a personal loan, the lender usually conducts a thorough investigation of your credit report. Each inquiry causes your credit score to drop a few points. However, this drop in score is only counted once in a one-month period; if you’re shopping for a loan by placing applications at multiple institutions, be sure to concentrate all your applications in the same month. Otherwise, with frequent and established applications over several months shows that you are probably in financial trouble and need to use credit too often.
Length of credit history: Every time you get a new source of credit, it reduces the average age of your accounts, which can lower your credit score slightly. For example, if you have had a credit card for 10 years and a car loan for three years, the average age of your accounts is 6.5 years. Add a brand new personal loan, and that average drops to 4.33 years. The length of your credit history, which also takes into account your oldest credit accounts and the last time you used credit, accounts for around 15% in most calculations.
It is also important to consider that personal loans cost money in the form of interest and other associated fees. If you consolidate credit card debt, you may be able to get a lower interest rate than you are currently paying and save money.
But if you’re applying for a personal loan just to build credit, consider the interest costs and ask yourself if there’s a cheaper way to build credit? For example, by using a credit card and paying it off in full each month, before accruing interest, you could build your credit at no additional cost.
Also, if you use a personal loan to consolidate credit card debt, make sure you don’t build up another balance on your credit cards. This could put you further into debt, which could affect your overall financial well-being and could have a negative impact on your credit.
What credit score is required to obtain a personal loan?
You can get a personal loan with just about any credit score. But it’s important to keep in mind that a better credit score will give you access to more lenders and lower interest rates.
For example, there are lenders who specialize in working with people with bad credit, but you may pay higher interest rates. However, the industry has grown greatly in the last 10 years and it is now possible to get smaller loans that do not require a credit check. Instead, these lenders rely on instant bank inquiries (IBV) which are based on a much shorter history (3-6 months) and do not involve complex calculations.
It is also important to keep in mind that lenders do not only look at your credit score to determine your eligibility and loan terms. Other factors that may be taken into account by lenders vary, but among the most common are
1- Employment stability
3- Other debts you have paid off
4- Negative elements of your credit file.
5- If you have a co-signer.
In some cases, lenders may require collateral in the form of savings or collateral before granting you a loan. While this can help you get a lower interest rate because it reduces the lender’s risk, it can be dangerous if you are short on cash.
If your need is not immediate, it may make sense to improve your credit before applying for a personal loan. Either by trying to pay off credit card balances, catch up on late payments, be careful, pay upcoming bills on time and avoid taking out new credit.
How to obtain a personal loan
You can get a personal loan from a variety of sources, including traditional banks, credit unions and online lenders. If you have excellent credit, you will have more options and it may be easy to get approved for a personal loan.
On the other hand, if your credit is not excellent, your options may be limited and you may have difficulty getting favorable terms.
Therefore, it is essential that you take the time to compare personal loans from several lenders before you apply. Many of these lenders allow you to be pre-qualified with a “soft” credit check, which will not impact your credit score. This process allows you to view and compare loan offers, including interest rates, repayment terms and more. As mentioned earlier, be careful to concentrate your applications in one month, or contact private lenders who use IBV.
Take the time to do your research and you’ll have a better chance of getting the right loan with the best possible terms.
The key to success: monitor your credit regularly to maintain good credit
Before and after you apply for a personal loan, it is essential to monitor your credit. This will not only help you understand what aspects of your credit history you need to fix, but it will also give you the opportunity to identify potential new problems and address them before they hurt your credit score.
Many financial institutions now offer you the ability to easily track your credit through various mobile apps. Some offer it for free and others offer it for a monthly fee. It is important to know that, in Canada, citizens have the right to make one request per year to the credit bureaus in order to obtain your credit report and score for free. Visit the Transunion and Equifax websites to learn more.
By focusing on building and maintaining an excellent credit history, you will be in a much better position to obtain affordable credit in the future, when you need it.