Personal loans are having a moment. According to data from credit reporting company Experian, they’re growing faster than any other type of debt, with the second quarter of 2019 alone seeing a collective balance of $305 billion in the U.S. Experian goes on to say that this number is double the growth of credit card debt.
One of the most popular reasons to take out a personal loan is to consolidate debt, but the question remains if this type of debt is good or bad for people’s credit. If you’re thinking of taking out a personal loan for any reason, this is how it might affect your credit.
The Many Uses of Personal Loans
If you’re new to personal loans, you might wonder what the point of them is — especially compared to the ease of applying for and using credit cards. There are, in fact, quite a few uses for this type of credit, and the typically lower interest rates (coupled with the fact that they’re a fixed-term debt and not one that can be continuously borrowed from) makes them an interesting product for many. Here are just a few reasons someone might consider taking out a personal loan:
- Pay off high-interest credit card debt
- Finance a large purchase
- Pay for home improvement projects
- Pay for wedding expenses
- Finance a trip
Besides what they’re used for, there can be some confusion on the topic of personal loans, particularly when it comes to payday loans. Payday loans, like personal loans, can be used for just about anything you wish. Unlike the typical personal loan, however, payday loans are short-term, high interest loans.
Payday loans also pack a punch in terms of interest rates, averaging triple-digit annualized interest rates. That kind of interest rate is not likely to be found with a traditional personal loan, the average of which Experian notes was just around 17 percent as of Fall 2018. In other words, payday loans might be easy to get when you need money in a pinch, but they come with a steep cost.
How to Get a Personal Loan
Years ago, getting a personal loan would mean going to your local bank or credit union and filling out an application. Nowadays, you don’t even have to leave the house.
The rise of online lenders has made it easier than ever to get a personal loan, as well as to shop around. The upside is that there are more personal loan options than ever. The downside is that it’s not always easy to see if what you’re applying for is a typical personal loan or a high-interest short-term loan.
Regardless of the downside, the popularity of online, unsecured loans being offered by FinTech companies can’t be denied. A TransUnion report from Winter 2019 stated that these types of loans “comprise 38% of all unsecured personal loan balances.” Five years ago, they only made up five percent — and this rate of growth coincides with the decrease of the same type of balances owned by banks and credit unions (making up 28 percent and 21 percent, respectively).
If you prefer to do your loan shopping online, you can ensure that you get the best deal for you by paying close attention to interest rates and repayment terms, and by being wary of any online lender that guarantees credit approval or requires a fee to be paid in advance in exchange for credit approval.
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How a Personal Loan Affects Your Credit
If you’re worried that taking out a personal loan will be detrimental to your credit, don’t be. A personal loan itself doesn’t hurt your credit (besides a short-term effect due to the bump in your total debt amount) — but how you apply for the loan and repay the one you get will have an impact.
How Applying for a Personal Loan Affects Your Credit
For starters, every credit application you submit can result in a hard credit inquiry and can take a few points off your credit scores. When it happens occasionally, those few points hardly make a difference. Done regularly, they can add up.
You simply need to follow the rules of rate shopping to strike a balance between shopping around for the best loan you can get and not taking a large hit on your credit scores. Here are three keys to rate shopping:
- Apply for all personal loans you’re interested in within a short timeframe, preferably within two weeks
- Always apply for the same amount
- Don’t apply for any other types of credit while you’re doing this
These steps indicate that you don’t intend to take every loan you’re approved for, but rather that you’re trying to see who approves you with the best terms. If you follow these rules, then you should only get dinged with one credit application.
Something that can also help with this is if you’ve received preapprovals for a personal loan, as you can know what you’ll likely get from that particular lender without even having to apply. You can also apply for a prequalification, which shouldn’t result in a hard credit inquiry unless you formally apply for credit after you see the prequalification offer. Just keep in mind that the terms of the loan you get could differ from the prequalification offer, which is more of an estimate than an exact offer.
How Having a Personal Loan Affects Your Credit
Once you have a personal loan, there’s something you can do to make sure it helps your credit: Always pay on time.
Payment history is the most influential factor for FICO® credit scores. Therefore, paying late can do real damage to your credit. If you pay the full amount due on time each month, then the positive payment history can actually help you build good credit.
While it’s true that adding to your total debt amount can have an effect on your credit scores, having more than one type of credit (such as a credit card and a personal loan) can help your credit. If the personal loan is a real need for you, you don’t have to avoid it for fear of adding to your debt load. Instead, just diligently pay on time, and your scores will likely only benefit from the personal loan.