Navigating the world of personal finance isn’t always the easiest, and sometimes, a situation may arise where you find yourself in need of a personal loan.
While personal loans can be an excellent way to pay for something you can’t immediately afford, you do need to pay them back in full plus interest, which means that they will affect your credit score. But how exactly do personal loans affect your credit score?
While personal loans often temporarily lower your credit score, this isn’t permanent. When you make your regular payments on time, have a history of effectively managing your debts, and do not apply for more than you can reasonably afford, your credit score will likely stabilize quickly or even improve. Paying off debt might initially lower your credit scores if removing the debt affects certain factors like your credit mix, the length of your credit history or your credit utilization ratio.
How Is a Credit Score Calculated?
A credit score is a 3-digit number determined by several factors relating to your finances. Think of it like your personal report card—a method for certain people to see your financial stability and capabilities. It’s a numerical way to show your creditworthiness to determine your risk-to-asset potential for potential lenders.
A credit score with a higher number determines that you’re a reliable person to lend money to and are less likely to be a risk to the lender. This often means that you’re more likely to get ideal interest rates and will have an easier time securing a loan.
Meanwhile, the opposite is true for lower numbers. A lower number indicates that you’re a riskier person to lend money to. With a lower credit score, you’re more likely to experience higher interest rates and may have a difficult time securing a significant loan.
This number, ranging from 300 to 900, is calculated based on factors such as:
- How long you’ve had credit
- If you have an active balance on any credit cards
- If you have a history of missing payments
- The amount of money you owe
- The number of recent credit applications
- The type of credit used
- Whether or not a debt collection agency owns any of your debts
- Any record of bankruptcy
Together, these factors determine your financial viability and risk.
How Do Personal Loans Work?
A personal loan is one of the most straightforward lending concepts — you receive a lump sum which you repay in installments over a pre-determined period. There are 2 types of personal loans:
- A secured loan, which requires collateral, usually in the form of an asset like a house or a car. This premise is simple—pay back the loan in full on time, and you keep your asset; if you do not, the lender may take the asset for you to recoup the cost of lending you money.
- An unsecured loan, which requires no collateral. If you do not pay your lender back, they may sue you or take money from your account to recoup the cost of lending you money.
This sum of money is intended for a purchase that you can’t immediately pay for yourself; you borrow money from someone who can, and then pay them back in regular installments. When you’re acquiring a personal loan, you end up repaying:
- The full cost of the loan
- Any additional fees
- Any interest on the loan
Personal loans often come from banks, credit unions, or other lenders. When you’re applying for a personal loan, make sure that you always read your paperwork thoroughly. Taking out a loan for any more than you can afford is an extremely risky financial endeavour.
To get a personal loan, you need proof of:
- Income
- Employment
- Your debt-to-income ratio
- Banking institution
- Address
One factor often contributes significantly to whether or not you’ll be approved for a personal loan—your credit score.
What Credit Score Do You Need for a Personal Loan?
While personal loans are often available to most people, your credit score will significantly affect the loan agreement you end up being offered. Usually, you’ll be offered more favourable terms and interest rates with a higher score, while the opposite is true for lower scores.
Most lenders often follow these guidelines. A person with:
- A score of less than 580 is determined to be below average and a risk to the business
- A score of 580-669 has slightly below-average credit and may be a risk to lend to, but may secure a loan at higher interest rates
- A score of 670-739 has average credit and most lenders will offer a loan at standard interest rates
- A score of 740 has above-average credit and will be considered a dependable borrower with ideal interest rates
- A score of 800 or higher is determined to be well above average and is significantly more likely to be approved with low interest rates and ideal terms
A good higher score demonstrates that you have a history of being financially responsible—and that you aren’t a risk to lend money to.
Can a Personal Loan Boost Your Credit Score?
When you apply for a personal loan, it’s going to affect your credit score. At first, it will likely cause your score to drop—especially if you apply for more than one loan at once. Some lenders look at this situation as though you’re taking on more debt than you can handle, which can be extremely risky.
When you receive a personal loan, you must begin paying it back over regular periods. As you make these payments, your credit score should return to normal.
Remember, your credit score is determined by your financial history of responsibility—actively paying your loan back on time may even lead to a significant increase in your credit score, though raising a credit score often may take some time.
It’s important to note that the benefits only apply when the loan is repaid appropriately and on time. If you miss any payments or can’t pay the loan back in full, it will lead to a lower credit score. Never take out a loan you can’t afford.
Where to Apply for a Personal Loan
At Blue Copper Capital, we believe that everybody deserves the chance to improve their financial situation, and a personal loan can often be an ideal way to achieve this. If you need a personal loan or financial advice or want to learn about improving your credit score, reach out to our team today—we’re here for you.
