Credit scores can be intimidating. What brings it up? What takes it down? How long does it take to change? People also tend to have questions that relate to their own needs, and if you’re considering a personal loan, you may be looking for answers.
Most credit scoring models use a variety of factors, and each one has a different impact. Here are some examples of factors used to calculate credit scores and how a personal loan might affect each one:
Payment history – Payment history is a significant factor in most credit scoring models.1 If you pay your personal loan according to the terms each month, it could raise your score.2 However, if you make late payments or miss a payment, it could damage your score.3
Amounts owed – The amount of credit card debt you have vs. available credit is another large factor.4 This is called credit utilization ratio. If you move credit card debt onto a personal loan, which is installment debt, it can instantly reduce your amounts owed and possibly raise your score.5 This is commonly how a debt consolidation loan works.
Length of credit history – The amount of time you’ve had credit can have a medium impact on your score.6 Generally speaking, opening a new loan may not have much of an effect on this scoring factor.
Types of credit used – One of the smaller factors in credit scores is your account mix.7 If you only have revolving debt like credit cards, adding installment debt can help diversify your types of credit and potentially give your score a bump.8
New credit – New credit, another small factor, includes the number of recently opened accounts and credit inquiries. Applying for one loan or opening one loan may not impact your score too much.9 But if you apply for several different loans in a short period of time, it could bring your score down.10
How to use a personal loan to help build credit
Now that you know how a personal loan affects your credit, use that knowledge to your advantage:
Improve or maintain payment history – Since payment history can be so important to creating a good score, paying your loan on time should be priority #1. This can also help you avoid late fees and other charges from your lender.
Reduce your credit utilization ratio – By paying off credit card debt with a personal loan, you can reduce the amount of revolving debt you owe. This could lower your credit utilization ratio and raise your score.
Add a different type of credit to your credit report – By adding a new or additional installment account to your credit profile, and keeping it in good standing, you may be rewarded with a score increase.
It all adds up
Credit scores reward you for good behavior and penalize you for being bad. In the case of personal loans, taking one out might not affect your score too much — it’s how you manage the repayment that counts. It’s also important to know that it may take time to build up your score, but the opportunity is there. For more information on boosting your credit, check out these tips to improve your credit score.
Sources: 1. Niemeyer, Brooke. “How Is My Credit Score Calculated?” Credit.com. https://www.credit.com/credit-repair/how-is-credit-score-calculated/ (accessed August 29, 2018).
2. Niemeyer, Brooke. “How Is My Credit Score Calculated?” Credit.com.