Credit Scores For Personal Loans: What You Need To Know
5-Minute ReadMay 20, 2022
People use personal loans for a variety of purposes, including remodeling a bathroom, financing a big purchase or consolidating debts into a single monthly payment.
Before taking out a personal loan, though, you first need to qualify. And that's where your credit, including your credit score, plays a large role. But just how important is your score when obtaining a personal loan?
In this article, we’ll explore good credit, how you get it and how your credit score impacts personal loan approval.
What’s A Credit Score?
In the early days of financial institutions, lenders had to try to judge creditworthiness based on previous interactions, blind chance and even factors we would consider discriminatory today such as age, gender or political and social affiliations.
Simply put, it wasn’t a great system. We needed data to help eliminate biases and make sounder, more objective approval decisions based on history. This led to credit bureaus forming. We know them today as Experian™, Equifax® and TransUnion®.
These bureaus gather data around your financial history, including loan and credit payments. However, when it comes to the credit scoring standard, there are two entities that take all this information and turn it into a number used to help evaluate where applicants stand: FICO® and VantageScore®.
FICO® has been through several different versions, and there are variations for specific industries as well, but this is the credit score accepted by most lenders. VantageScore® is a competing system that aims to give consumers more insight into what’s affecting their score to help improve it. Although not identical to the FICO® formula, it’s similar enough to offer actionable steps to better credit.
When you check your own credit, you’re typically getting a VantageScore®. Without impacting your score, you can get your VantageScore 3.0® credit score and report for free every week from our friends at Rocket HomesSM. You also get tips on how you can better your credit based on the information in your report.
What Makes Up Your Credit Score?
While the real formulas that make up a FICO® Score are a bit of a black box, the relative weights of what goes into your score is easily available.
1. Payment History (35%)
This one is the most straightforward. If you regularly make your payments on time, it’s good for your credit score. Payments that are 30 days or more late, not so much. Also included in this category are potential negative marks like charge-offs, collections and bankruptcies. While charge-offs and collections remain on your report for 7 years, a bankruptcy may stay there for 7 or 10 years, depending on the type filed.
2. Amounts Owed (30%)
The second biggest category in terms of its effect on your credit score is the amount owed on your debt. On a monthly basis, this is where you exert the most control over your credit score. The reasoning for this is pretty simple.
What you can control is the amount of spending you have on things like credit cards and other lines of credit. You want to use your accounts regularly, but not so much that it looks like you’re overextending yourself. As a general rule, you don’t want to utilize more than 30% of your overall credit limit. So, if you had $10,000 in overall limits, you wouldn’t want to have a balance of more than $3,000 at any given time. If you have to carry a balance, you want to keep it as low as possible to avoid paying more than necessary. And remember, credit cards tend to come with high interest rates.
3. Length Of Credit History (15%)
If you have a long history of making on-time payments with a varied mix of revolving and installment loans, you’ll have a better credit score than someone who is just starting out since there’s more history for lenders to go off.
4. Credit Mix (10%)
Lenders want to see a mix of installment loans like car payments, personal loans, student loans, etc., and revolving accounts for things like credit cards. This shows that you can responsibly handle different types of debt, and you’ll increase the lender’s confidence that you will be able to repay your loans.
5. New Credit (10%)
Every time you get a new loan or credit card, your credit score takes a temporary hit. Don’t panic! The idea is that it’s signaling you could be in financial trouble if you need a new loan or credit card. However, if you make your payments on time and pay balances down or even off, your credit score should go back up within 3 months or so.
How Credit Affects Your Loan Approval
Now that you know the essentials of credit scores and how they’re calculated, let’s look at how your score will impact the odds of obtaining a personal loan. Simply put, the better your credit, the better rates and terms you’ll be able to get, along with a better chance of getting approved.
When lenders look at your options for any loan or line of credit, including personal loans, they pay attention to two factors that are very specific to your credit: your credit score and your debt-to-income ratio (DTI). Let's take a quick look at those.
What Credit Score Is Needed For A Personal Loan?
Each personal loan gets evaluated on an individual basis and requirements vary by lender, but, in general, to get approved for a loan with good terms, you’ll want a credit score of 650 or higher, although some lenders do accept lower scores. That range may vary a bit depending on whether you have a previous relationship with the lender. If you showed them a good payment history in the past, then they may be more flexible with their offers.
Which FICO® Score Counts?
We’ve touched on FICO® Score importance, but it’s also important to understand how it works regarding loan approval. One way lenders may look at your score is by taking the median credit score from the three bureaus for qualification purposes. If you have two or more borrowers qualifying for a loan, lenders would then take the lowest median score.
As an example, let’s say you’re applying with a cosigner for a loan. If you have credit scores of 720, 700 and 690, and your cosigner has scores of 660, 640 and 620, the score that counts for qualification purposes is 640.
In some cases, other lenders may only look at scores from one or two bureaus. If two bureaus are looked at for credit qualification, the lender will probably take the lower of the two scores for qualification purposes.
Understanding Debt-To-Income Ratio
Your DTI is another important item that has a big impact on whether you’re approved. DTI looks at your monthly payments on installment debt like mortgages, car payments or student loans along with your minimum monthly payments on credit cards or other lines of credit. DTI gets compared with your gross monthly income. The formula is as follows:
Installment Debt + Revolving Debt Payments / Gross Monthly Income
Let’s look at a quick example. You have a monthly income of $4,000. Between several accounts, the combined minimum payment on your credit cards is $200. Your revolving debt is a car payment of $300, student loan payments of $400, and a $950 mortgage payment. This makes your DTI 46.25% ($1,850/$4,000).
Although lenders evaluate loans on an individual basis, in general, the lower your DTI, the better the chance you have to qualify for a loan. It’s important to note that if you have an existing relationship with the lender or one of its affiliates, you may be able to qualify with a slightly higher DTI if you’ve shown a history of the ability to make your payments in the past on your previous or existing loans. Other things like whether you're self-employed can factor in here as well, so there’s no one-size-fits-all formula.
Use Our Debt-To-Income Calculator To Find Your DTI
Credit Impact Of Your Application
When lenders look at your credit, there are two types of checks that take place: soft inquiries and hard inquiries.
Soft inquiries don’t impact your credit score at all. These may get used when you’re shopping around for certain types of loans, such as personal loans, and want to check your options. These are also the types of credit checks used when you check your own credit or get considered by a prospective employer.
Hard inquiries do impact your credit score. You get a hard inquiry any time you actually apply for a new loan or credit card. At that point, it’s reported to the credit bureaus, and affects your score for a while.
At Rocket Loans, we let you check your loan options by just doing a soft credit pull. We don’t do a hard pull until you're ready to move forward with your application.
Ready To Apply?
A personal loan can be a big help in achieving your personal goals, whether that’s consolidating debt or paying for a wedding. It’s always important, however, to understand exactly what you’re getting into. Now that you know what you should expect when it comes to personal loans and credit, consider taking the next step toward financial freedom with our personal loan process.
Ready To Improve Your Financial Life?
Apply for a personal loan today to consolidate your debt.Apply For A Loan
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