Payday loans are deficient in many ways. They’re ridiculously expensive, often predatory, and consistently trap borrowers who have no other source of financial support. But how do payday loans affect your credit score?
Typically, they only impact your score when you fail to pay them back on time. Unfortunately, the likelihood of default is much higher with payday loans than with other sources of financing. This guide will explore the connection between payday loans and your credit to help you prevent or recover from any damage done to your score.
How are credit scores calculated?
Before you can fully understand how a payday loan affects your credit score, you need to know how lenders calculate your credit score in the first place.
Lenders derive your credit score by applying a proprietary formula to the information in your credit reports. They can use any of a dozen methods, but most revolve around the same five basic criteria.
In approximate order of importance, those criteria are:
- Credit utilization and outstanding balances
- Payment history and general track record
- Length of credit history and age of accounts
- Number and diversity of credit accounts
- Recent credit activity, especially applications for new debt
Lenders apply their preferred formula to the details in one or more of your credit reports from the three major credit bureaus: Equifax, Experian, and TransUnion.The resulting score is an approximate representation on a scale of 300 to 850 of how risky it would be for them to lend to you.
Do payday loans have a direct impact on your credit score?
Payday lenders usually don’t report their day-to-day activity to any of the three major credit bureaus, which means that neither the act of taking out a payday loan or making payments toward it will show up on your credit report.
Because these activities aren’t recorded, traditional lenders won’t include them in their calculations, and they won’t have an impact on your credit score.
That might sound like a positive at first glance, but it’s just another item in the long list of reasons to avoid payday loans. Successfully paying off a loan (even a payday loan) will generally increase your credit score.
But most payday lenders won’t report your good behavior, so you usually can’t use them to rebuild your credit. They keep all your payments a secret… until you stop making them.
How payday loans can affect your credit score
When you fail to pay back your payday loan (which studies have shown as much as half of borrowers eventually do), your lender has a few ways of trying to collect. And unfortunately, almost all of them will negatively affect your credit score.
Usually, that looks like one of the following:
- Debt collectors: If your payday lender decides to sell your loan to a debt collector, the collector will be under no obligation to keep your default a secret from the credit bureaus.
- Lawsuits: Your payday lender has the right to sue you when you breach the terms of your payday loan. If you’re taken to court and ruled against (either because you’re guilty or simply fail to show up), it will be reported to a credit bureau and damage your credit score.
To top it off, an account in collections and a lost lawsuit both negatively impact your “payment history,” which plays one of the largest roles in calculating your score.
Payday loans are, once again, the worst of both worlds: You won’t receive any reward for good behavior or responsible use, but you’ll definitely receive punishment for defaulting.
How to avoid credit damage from payday loans
It’s difficult to take out payday loans without getting burned eventually, but it is theoretically possible. If you use them responsibly and intelligently, you might be able to avoid damaging your credit score.
First, you’ll need to be particular about choosing a payday lender. Look for one who won’t perform a hard inquiry before lending to you.
A hard inquiry happens when a lender pulls your credit history, and too many can lower your credit score by a few points. Many payday lenders don’t require a credit check, but you shouldn’t assume that’s the case without double-checking.
Second, you’ll need to make sure that you can pay back your loan on time and in full. If you ever default on a payday loan, you’ll see a significant hit to your credit score one way or another.
Can you remove payday loans from your credit report?
If one or more payday loans end up on your credit report and are damaging your credit score, it’s going to take a lot of time, effort, or both to have them removed.
That said, there are a few ways for you to have a payday loan (or any other debt) taken off of your credit report.
The most common ways are:
- Dispute of an Error: If you think that a payday loan has been mistakenly entered onto your credit report, you can write to a credit bureau and request that the error be investigated and potentially removed. If you find a clerical error or have been the victim of identity theft, this is the best way to take a payday loan off of your credit report.
- Negotiation with the Lender: If the loan you’re trying to remove isn’t due to a mistake and does belong on your credit report, it will be much more difficult to get it taken off. In this case, your best option is to negotiate with the reporting lender. If you offer to pay the old debt in full, they might be willing to remove the negative entry from your report.
- Goodwill Requests: Of course, since you did default on the debt, you might not have the means to pay it off. If you can’t make payments on the loan you wish to have removed from your credit report, it’s still worth asking the lender to do so out of the goodness of their heart. The worst they can say is no, and they might be lenient, especially if you’re profitable in some other way and they want to keep your business.
If none of these strategies work, you may simply have to wait out the problem. It’s not ideal, since the damage can limit your credit options, but the loan will be removed from your report after seven years.
And in the meantime, there are other strategies you can take that will help rebuild your credit score.
How to rebuild your credit score after payday loan damage
Building good credit is a long-term game. A large percentage of your credit score is demonstrating discipline with your credit to lenders over a long period.
If you’ve damaged your score by defaulting on a payday loan, it’s going to take time to rebuild it, no matter what. After all, there’s not much you can do to speed up the growth of the average age of your credit accounts.
But if you take a look at the formula we discussed above for calculating your credit score, you’ll see that there are a handful of ways that you can actively drive up your credit score relatively quickly.
Here are a few good examples:
- Reduce your outstanding balances: Your credit utilization is one of the biggest factors in calculating your credit score. The best way to lower your utilization and increase your credit score is to pay off your outstanding balances, especially on the accounts where you’re nearing your limit.
- Increase your overall credit limits: Of course, your outstanding balance is just one half of the utilization calculation. If you can increase your total available credit (the denominator in the utilization calculation) you can have a similar effect. This might be difficult if your score has significantly lowered your creditworthiness, but you may be able to get a lender to increase your credit limit if you have a good relationship with them.
- Open new types of accounts: If you can’t get your existing lender to increase the limit on your current credit account, you may be able to qualify for a loan or credit card with another lender that’s more inclined to lend to someone rebuilding their credit. This can also double as a way to diversify the type and number of your credit accounts.
While these have the potential to drive your score up quickly, there is a limit to their effectiveness. The rest is going to come down to your discipline over the long-term.
Make your debt payments on time, every time. Try to avoid taking out any more payday loans since those are so difficult to repay and are what got you in trouble in the first place.
If you’re struggling to keep up with your payday loans, Debt Hammer can help. We specialize in helping people get out of the payday loan trap, so if you’re looking to avoid defaulting and damaging your credit score, contact us today.