Taking out a personal loan has the potential to impact your credit score, be it negatively or positively. Whether the effect is positive or negative will largely depend on whether you meet repayments on time or not.
How Is a Credit Score Calculated?
When people make reference to a credit score, they are referring to a number that reflects a consumer’s creditworthiness. The higher the credit score, the better the borrower profile. A credit score is made up of a few factors including number of open accounts, level of debt, repayment history and credit mix.
Each of the three main Credit Reference Agencies (CRAs) will have a different way of working out what your credit score is. This means that there’s no one number when it comes to your credit score, but a variation of your score depending on the CRA. The three credit reference agencies are Experian, Callcredit and Equifax.
How Do Personal Loans Affect Your Credit Score?
Personal loans can affect your credit score at different stages, from the initial research phase all the way through to debt consolidation.
If you are searching for a loan, be aware that even these initial searches have the potential to impact your credit history as many of the details you will have to enter include things such as your earnings and level of debt. Additionally, any loan applications can impact your credit score, particularly if the application is rejected.
Borrowers who can regularly meet repayments for their personal loans and who can effectively manage any debts can positively impact their credit score.
Some things are not included in your credit score, including student loans, rent, bank account balances, medical records, transactional data (what you spend your money on) and criminal records.
How Does Applying for a Loan Affect Your Credit Score?
When you apply for a loan, any credit agencies that you are working with will be notified as they will need to assess your financial situation and ensure that you can afford loan repayments.
Overall credit history tends to carry more weight than a single loan application in terms of how much it affects your credit score. Thus, if you have a generally good credit history (i.e. you meet repayments on time and effectively manage your debt), this will most likely supersede any impact made by a new loan application.
Could a Personal Loan Boost Your Credit Score?
If you take out a personal loan and regularly meet repayments on time, it is possible to boost your credit score as it shows you to be a responsible borrower.
However, it should be noted that many people need to take out a personal loan due to being in poor financial circumstances. If this is the case, it may not be advisable to take out a personal loan in order to build credit.
How Can I Use a Personal Loan To Build Credit?
There are different ways that personal loans can be used to improve your credit scores:
- Increase your credit history – the longer you have a credit account, especially one which shows responsible debt management, the better it looks to lenders. In order to start building your credit history, taking out a personal loan and meeting all payments on time can be a good starting point.
- Improve / maintain credit history – payment history represents 35% of your credit score so has the potential to make a big impact. If you take out a personal loan, regularly making monthly payments on time will positively boost your credit.
- Reduce your credit utilisation ratio – your credit utilisation ratio is the amount of revolving credit you are using relative to how much you have left. You can reduce the amount of revolving debt you owe by paying off credit card debt with a personal loan. This will lower your credit utilisation ratio and raise your credit score.
- Diversify the type of credit on your credit report – different types of credit can benefit your credit as credit mix represents approximately 10% of the credit score. Taking out a personal loan can help strengthen your credit and diversify your profile.
Can Certain Types of Personal Loans Help To Build Credit?
Any personal loan paid back on time can have a positive impact on your credit. However, a couple of loans are specifically designed to build credit.
1. Credit-builder loans: Credit-builder loans are good for starting a credit score from scratch or if you have poor credit. They help borrowers start to build a positive payment history and are usually for smaller amounts of credit. The borrower makes deposits payments into a dedicated savings account and will receive the money after the repayment period minus any interest or fees.
2. Debt consolidation loans: Debt consolidation loans could be a good option for those who have multiple debts with high interest rates. You can take out a debt consolidation loan in order to streamline your debt and leave you with just one loan to manage. Depending on your credit score, you may also be eligible for a lower interest rate.
This could help your credit in the long-run as not only does it make your payments easier to manage, on-time payments can help to boost your credit score over time.
3. Secured personal loans: Secured loans require the borrower to put forward collateral to secure the loan. Although the money can be used for any purpose, if your goal is to build credit, a good strategy is to save the money and repay the loan over time.
How Quickly Will a Loan Build Credit?
Building credit using a loan is not a fast process. Usually, it takes at least six months to generate your first credit score and much longer in order to establish a good or excellent score.
Should I Take Out a Loan To Build Credit?
A personal loan can cause a slight hit to your credit score on a short-term basis but regularly, timely payments can quickly boost it back up and positively impact your credit. The strategy of taking out loans in order to build credit will only work if you can afford to repay the loan on time.
If you default on the loan or make any late payments, your credit score will be negatively impacted and that can be hard to come back from. Not only can it detrimentally impact your credit score, it can reduce your borrowing power for other lines of credit in the future.
