One of the easiest ways to borrow money is through a personal loan.
It's also a cheap way to borrow money, and the best personal loans let you pay off the loan early, so it can also be flexible.
Like many types of credit, a personal loan can impact your credit score.
Whether it positively or negatively affects your credit rating depends on several factors. That doesn't mean you shouldn't take one, but you should consider the effects and weigh the pros and cons before making a choice.
From your ability to make your loan payments on time to your credit utilisation ratio.
This article will explain how a loan affects your credit score.
Let's start by looking at how your credit score works.
Many people are surprised to learn that there is no universal credit score system. In fact, you're likely to have at least three separate scores and credit reports in the United Kingdom rather than just one credit score.
This is because three main credit referencing agencies (Equifax, Experian and TransUnion) use a different methods for scoring borrowers.
You may have a credit score of 600 with one agency, another may give you a score of 895, and the other may give you 999.
No matter which credit report you look at, the information you see has been provided by lenders.
Lenders providing positive information to the credit reference agencies can help you build a good credit score over time.
If the information they provide is negative, this could damage your credit score and make it harder for you to access loans with generous terms and affordable interest rates.
Personal loans can help you improve your credit score if you use them responsibly.
Here’s how a personal loan can positively affect your credit score.
When you take out a personal loan, paying on time and in full is perhaps the most effective way to build a strong payment history and protect your credit score.
Think of your credit report as a CV or portfolio that you show to potential lenders. Ideally, you want it to show that you're responsible, organised and you've had lots of experience. This might be less effective if it makes you look unreliable and forgetful.
By managing your loan sensibly, you can make a big difference to your credit report and improve your ability to borrow more money in the future.
When credit referencing agencies are calculating your credit score, they often consider your 'credit mix'.
This refers to the different types of credit you have access to.
A strong credit mix might include- a personal loan, credit card and mortgage, for example.
Managing several different types of credit responsibly shows lenders that you can make timely payments - even when juggling multiple debts.
However, as we're about to explain, having access to multiple lines of credit can be risky.
Since personal loans are classed as instalment loans, they won't factor into your credit utilisation ratio. And this is a good thing!
Your credit utilisation ratio refers to the revolving credit you use.
If, for example, you have a credit card limit of £1,000 and you carry a balance of £800 most of the time, this means you have a credit utilisation ratio of 80%.
Generally, if you want to maintain a healthy credit score, keeping your credit utilisation below 30% is a good idea. So if you have a credit limit of £10,000, you’ll only ever use £3,000.
Keeping this utilisation ratio low can be challenging if you rely on credit cards, but with a personal loan, the amount of credit you're using won't be considered.
Some people use a personal loan to pay off credit card debt, replace revolving credit with an instalment loan, and boost their credit score.
Now that we’ve discussed the positives, how does a personal loan negatively affect your credit score?
When you apply for a type of credit, whether a personal loan, credit card or mortgage, the lender in question will do a credit check to assess your credit history.
This credit check will leave what's known as a 'hard’ search on your credit report. Other lenders can see a hard search and negatively impact your credit score.
The impact on your credit score can vary depending on the credit reference agency in question, but the good news is it will usually only last a few months.
A few months after you apply for a line of credit, your credit score should recover. You'll speed up the process by managing your debts and making timely payments.
Applying for several lines of credit in a short time can have an even bigger impact on your credit score.
This is because each credit application will result in another hard check.
Potential lenders may assume you're desperate to borrow money when they see multiple enquiries on your credit report. This may make them reluctant to approve your application.
To avoid this problem, it's a good idea to spread your credit applications apart so that your credit score has a chance to recover in between applications.
The more debt you have, the harder it may be to stay on top of your repayments.
If you take out a personal loan to pay off other types of debt with a higher interest rate, make sure you can pay this new debt on time and in full.
Of all the possible things that can hurt your credit score, missing monthly payments tend to have the biggest impact.
When you miss a loan repayment, the lender usually reports this to credit reference agencies.
Lenders usually have a time limit to determine when a missed payment counts late.
This can vary from one lender to the next, so it's worth finding out how much leeway your lender will give you.
If you manage to make the payment before the late payment date, you may manage to avoid the credit bureaus finding out.
You can also avoid missed payments by:
Creating a budget so you know exactly what you can afford
Writing payment dates on a calendar, so you know when money is due
Setting up automatic payments, so you don't have to think about them
If you apply for a personal loan that comes with a high-interest rate, this can increase the cost of borrowing and make your debts harder to manage.
It's a good idea to compare a few different personal loans before making an application.
That way, you can avoid spending more on interest than you have to.
It’s a good idea to try to improve your credit score with each credit reference agency, but the number itself tends to matter less than the information on your credit file.
See your credit score with each agency as an overall representation of your borrowing history and ability to manage debt effectively.
By managing your debt effectively, you can prove you’re a sensible borrower and increase your chances of accessing affordable lines of credit in future.