Personal loans are great sources of cash when you have to pay for unexpected expenses. But like any other form of credit, a personal loan can affect your credit score in many different ways. And depending on the state of your credit, getting a personal loan can either help or hurt your credit score. 

It's essential to understand how this financing option can impact your credit score either positively or negatively so you will be able to prepare yourself for each outcome. This way, you can also make a more informed decision whether or not a personal loan is a right choice for you.

Keep reading and find out the possible effects of personal loans on your credit score. 

Understanding Your Credit Score

Before going over the impact of personal loans, it's best to understand first how your credit score works and its components. A credit score can range from 300 to 850 and shows how responsible you are in handling your credit. Thus, the higher your score is, the better you manage your finance based on your credit report's information. 

The following are the five factors that determine your credit score, and each counts for a set of percentage: 

• Payment History (35%) 

• Amounts Owed (30%)

• Length of Credit History (15%) 

• New Credit (10%) 

• Credit Mix (10%)

As you can see, the amount of debts you have and how reliable you are at paying them off have the biggest percentage on your credit score. With that, it is safe to say that the effects of personal loans greatly depends on how you manage them. 

Positive Effects of Personal Loan

Personal loans can help build or improve your credit score if you know how to use them properly. For instance, being consistent about making payments on time can result in positive outcomes. 

Nevertheless, here's how a personal loan can help your credit: 

Diversify Credit Mix

Having a rich combination of different types of credit can help raise your score. If you don't yet have a personal loan, it can help diversify your credit mix. A personal loan adds installment credit to your profile, which is a different form of credit than the revolving credit linked to credit cards. 

Establish A Positive Credit History

Payment history is the most vital factor in calculating your credit score. If you make your personal loan payments on time, you can build a positive credit history and, in turn, increase your credit score. Thus, make sure to pay your personal loan monthly repayment consistently and promptly. Setting a monthly budget and sticking to it can help you achieve this. 

Lower Credit Utilization Ratio

Consolidating higher interest debts into a personal loan with a lower interest rate can boost your credit score. Since you may be able to pay off your debt quicker with a single personal loan, you can reduce the amount you owed or your usage of available credit, which comprises 30 percent of your credit score. 

Negative Effects of Personal Loan

Taking out a personal loan also comes with some downsides. Before you decide you commit any personal loan, it's important to be aware of each of them to minimize their risks as much as possible. 

Highlighted below are ways in which a personal loan can hurt your credit: 

Trigger Hard Inquiries

Each time you apply for any form of credit, such as personal loans, the lender runs a credit check that may result in a hard inquiry. Note that a hard inquiry can decrease your score by up to five points. This can happen, especially if you apply for personal loans from multiple lenders within a short period. It may help to ask the lender upfront if the credit check is a hard or soft pull. 

Result In Negative Payment History

A personal loan can negatively affect your credit score if you don't make payments on time. Although missing a due date by a few days won't usually hurt your score, payments that are made more than 30 days late can drop your score up to 90-110 points. If you're getting a personal loan, ensure that you make the payment in full and on time every month. 

Increase Your Debt Load 

Getting a personal loan can increase your debt load. It can further increase your credit utilization if you already accumulated numerous debts. If it's beyond the ideal total utilization ratio, which is 30 percent, your score may be negatively affected in the process. It would be best to calculate your utilization ratio before opening a loan. 

Final Thoughts

Taking out a personal loan is beneficial if you know how to use it responsibly. If not, you may find yourself in a stressful financial situation that is harder to get out of. So before you get overwhelmed by getting a personal loan, consider weighing all your options and their possible outcomes. It would also help to check on your financial habits from time to time.