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By Katie Pins
If you’re thinking about taking out a personal loan, you may be wondering how it will impact your financial goals. A higher credit score is something we’re all striving toward. So, will a personal loan help or hurt your credit score? The short answer: it depends. So, let's take a look at how personal loans impact your credit score.
A personal loan is usually an unsecured loan, which means it does not require collateral such as a house. Personal loans can be used for many different things, including debt consolidation, home renovations or emergency expenses. It can also be used for the “fun stuff” in life like weddings and vacations.
Personal loans typically have lower interest rates than credit cards, so they’re good for large purchases. They’re also good for consolidating multiple loans or credit card debts into a single monthly payment. Instead of worrying about paying different bills at different times and rates, consolidation could help simplify your payments.
Positive payment history: Payment history makes up 35 percent of your FICO credit score. If you want to demonstrate to future lenders that you can make payments on time, a personal loan can help you show that. As long as you make monthly payments on time and in full, a personal loan could help boost your credit score. This is especially true if you have never had a loan before.
Lower credit utilization ratio: If you use a personal loan to consolidate credit card debt, you could lower your credit utilization score. Credit utilization makes up 30 percent of your score. Credit utilization comes from your revolving lines of credit (i.e. home equity lines of credit and credit cards). It is the ratio how much you owe compared to your total credit limit amount. For example, you have two credit cards with a total credit limit of $5,000. You owe $4,000 at the end of the month. So, your credit utilization is 80 percent.
When you consolidate credit card debt with a personal loan, you move the debt from the revolving line of credit (the credit card) to the personal loan. In the same example, if you move all $4,000 to a personal loan, your credit utilization would become 0 percent. It’s best practice to keep it under 30 percent, so moving debt from a credit card could give your score a big boost.
Another type of credit: Credit types and total accounts make up 10 percent of your credit score. Your score considers your different loans: a mortgage vs. student loans vs. credit cards. All of these loans contribute differently to your score, so having a variety of loan types could boost your credit score. A personal loan is yet another type of loan and can add that credit score the boost you may need if you make payments on time and in full.
Slowly lowering your debt-to-income ratio: Debt-to-income (DTI) is not part of your credit score, but lenders typically look at it when you apply for a loan or credit card. To calculate your DTI, take your total monthly debt payments and divide it by your monthly income.
You may be wondering, how can taking on a new loan help your DTI ratio? In the long run, if you are using a personal loan to consolidate high-interest debt into a lower interest rate loan, you may be able to pay off your debt quicker. As you pay off your debt, your debt-to-income ratio may decrease (as long as you’re not taking on new debt).
Negative payment history: Payment history is one of the most important factors in your credit score. If you don’t make your personal loan payments on time and in full each month, your credit score could take a dip. It’s important to evaluate the monthly payment before opening a personal loan.
Another credit inquiry: Credit inquiries make up 10 percent of your score. A credit inquiry decreases your score when someone checks your credit with a hard pull. When you apply for any loan, it’s good practice to ask upfront if the credit check is a hard or soft pull. Often, a credit pull only impacts your credit for a short time.
Increasing your debt-to-income ratio: Your DTI matters for two reasons. If it’s too high, it can prevent you from opening a new loan like a mortgage. Also, if it’s too high, it could put you in a stressful financial situation. Even though DTI is not a factor in your credit score, you should calculate your DTI before opening a new loan. A healthy DTI is below 40 percent.
Have a plan: Before applying for a personal loan, create a plan for how you will use the loan and how you’ll spend it. This plan will help you calculate how much money you’ll need because it’s important to only borrow what you need.
Take advantage of low rates: Personal loans are great for those big expenses. Before charging that bathroom renovation on your credit card, take a look at your personal loan options. You may be able to pay for that expense at a lower interest rate.
Don’t forget about other debt: I know—how could you forget about debt?—but hear me out. After you consolidate credit card debt in a personal loan, it’s easy to see that low balance on your credit card bill and increase your spending again. Don’t forget about the debt you’re working to pay off. Create a plan to reduce spending as you pay off your personal loan.
Katie Pins is a marketer fascinated with finance. Whether the topic is about the psychology of money, investment strategies or simply how to spend better, Katie enjoys diving in and sharing all the details with family, friends and Money Mentor readers. Money management needs to be simplified and Katie hopes she accomplishes that for our readers. The saying goes, "Knowledge is Power", and she hopes you feel empowered after reading Money Mentor.