Like many types of credit, a personal loan can have an impact on your credit score. Whether it has a positive or negative affect on your credit rating depends on a number of factors. From your ability to make your personal loan payments on time, to your credit utilisation ratio.
So, how does a personal loan affect 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, rather than having just one credit score, you're likely to have at least three separate scores and credit reports in the United Kingdom.
This is because there are three main credit referencing agencies (Equifax, Experian and TransUnion) and each one uses a different method 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.
If lenders provide positive information to the credit reference agencies, this 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 in future.
Personal loans have the potential to help you improve your credit score, as long as you use them responsibly.
Here’s how a personal loan can affect your credit score in a positive way.
When you take out a personal loan, paying on time and in full is perhaps the most effective way of building a strong payment history and protecting your credit score.
Think of your credit report like 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. If it makes you look unreliable and forgetful, this might be less effective.
By managing your personal loan sensibly, you can make a big difference to your credit report as a whole and improve your ability to borrow more money in future.
When credit referencing agencies are calculating your credit score, something they often take into account is your 'credit mix'.
This basically 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.
By managing several different types of credit responsibly, you can show 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 installment loans, they won't factor into your credit utilisation ratio. And this is a good thing!
Your credit utilisation ratio basically refers to the amount of revolving credit you're using.
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%.
As a general rule, if you want to maintain a healthy credit score, it's a good idea to keep your credit utilisation below 30%. So if you have a credit limit of £10,000, you’ll only ever use £3,000 of it.
Keeping this utilisation ratio low can be a challenge if you rely on credit cards, but with a personal loan, the amount of credit you're using won't be taken into account.
Some people choose to use a personal loan to pay off credit card debt so that they can replace revolving credit with an installment loan and boost their credit score in the process.
Now that we’ve talked about the positives, how does a personal loan affect your credit score in a negative way?
When you apply for a type of credit, whether it's 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. A hard search can be seen by other lenders and will negatively impact your credit score.
The exact impact it has 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 effectively and making payments on time.
Applying for several lines of credit in a short space of time can have an even bigger impact on your credit score.
This is because each credit application will result in another hard check.
When potential lenders see multiple enquiries on your credit report, they may assume you're desperate to borrow money. 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 will usually report this to credit reference agencies.
Lenders usually have a time limit to determine when a missed payment counts as 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 of the credit reference agencies, but the number itself tends to matter less than the information that's held on your credit file.
Try to 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.