Personal loans are a necessary part of the average person’s life. While we’d all like to get through life without borrowing any money at all, this isn’t a realistic thing for almost anyone. Even people who are independently wealthy usually borrow money at one point or other – to buy a thing, to build a thing, to finance some large new endeavor. The question is: How do we set up personal loans so that they don’t damage our personal credit? The good news for future money borrowers is that there are ways in which to organize these loans so that they actually improve a credit score, not weigh it down. Here’s how it works.
Personal credit is managed by three different private companies. These companies are independently owned, yet empowered by the government to accurately represent the creditworthiness of consumers in credit histories and the all-important credit scores. Lots of great sources have information about borrowing in their personal lending sections. We’ll cover some of the information about how that works here.
First of all, it’s important to understand that the credit reporting agencies aren’t actually allowed to look into your bank accounts. They don’t know how much money you have. What they do know is how you make certain purchases and how you use your credit. Credit reporting agencies are allowed to look at certain credit card information. For example, they know what your credit limits are. They also know how much of these credit limits you actually use. For example, if you have a credit card with $5,000 of available credit, and you use $4,000 of that from month to month, the credit reporting agencies will likely lower your score.
This is because it will appear that you are borrowing money (the outstanding balance of that credit card) to live your everyday life. The most sensible thing for a person with cash to do would be to pay off outstanding credit card balances, because credit card debt is so expensive to hang onto. By observing that you have high credit card debt, the CRA’s can make the judgement that you likely don’t have the financial means to pay off your debt, and are therefore somewhat financially vulnerable. Your associated low credit score will tell other lenders that you likely can’t handle the financial responsibility of another credit card or personal loan, so you should be denied the loan or be charged more money in interest and fees to make up for your likelihood of defaulting on that loan.
There are many other ways that CRA’s determine personal creditworthiness. Without getting into the weeds, it’s important to request new loans very infrequently, and only when you have little other personal debt and/or have the means of paying off the new loan comfortably and quickly/in a timely manner. If you are in a vulnerable financial position when requesting a personal loan, it is likely that your credit score will suffer. Unless you are able to endure a low score or have the means to quickly change your credit behaviors in the not-distant future, then it is best to avoid taking out a new loan until you can borrow more comfortably.