Personal loans are a popular choice when you’re looking for additional funds. Whether it’s to cover an unexpected bill, consolidate debt or pay for something that doesn’t fit into your monthly budget — personal loans can be a helpful financial tool.
But how do they affect your credit score?
The truth is that these types of loans can affect your credit score in a number of ways, and some of it will depend on the lender. Let’s explore some of the ways a personal loan can impact your credit score both positively and negatively.
How does a personal loan affect your credit score?
It depends on whether or not your lender reports to credit bureaus such as Experian, Equifax and TransUnion. If your lender doesn’t report to the credit bureaus, there is much less of a chance your personal loan will have an impact on your score — but, you’ll miss out on the opportunity to build your credit score.
When you apply.
When you submit a loan application, many lenders will run a hard credit inquiry to assess your creditworthiness and make their loan decision. A hard credit check can temporarily lower your credit score by a few points. The impact is typically minimal and short-term, meaning your score can bounce back, especially if you manage your credit well.
However, there are some lenders who check eligibility by only running a soft inquiry. Unlike a hard inquiry, a soft credit check won’t impact your score. This can be a good way to shop around for lower interest rates and compare loan offers. Keep in mind, the lender may still run a hard credit check to determine final approval.
Your overall credit mix.
Having a mix of different types of credit can help demonstrate your ability to manage your finances, which is why your credit mix makes up 10% of your FICO Score. Personal installment loans are different from revolving credit such as a credit card or line of credit. Having both types can help improve your credit mix and build your credit history.
Number of new credit accounts.
Opening a new credit account can impact your length of credit history by lowering the average age of your accounts. This can have a negative impact on your score, especially if your other accounts are relatively new as well. Lenders prefer to see a longer credit history, because it demonstrates reliability and experience managing debt.
Your repayment history.
Your payment history has the biggest impact on your credit score. Regardless of whether you’re checking your FICO Score or VantageScore, both scoring models consider your repayment history to be the most important factor.
This means that making on-time payments can help you build credit history and improve your score.
However, late or missed payments can have a negative effect on your credit score. Late payments can stay on your credit report for seven years. While the impact lessens over time, your score won’t fully recover until they’ve fallen off. Additionally, even if your lender doesn’t report to the credit bureaus, they can send your debt to collections which almost always reports to the credit bureaus.
Your credit utilization.
When you take out a new loan, it increases your overall amount of debt. While this can temporarily lower your score, if you’re paying off the debt and building a positive payment history, the effect won’t matter as much. The good news is installment loans, unlike revolving credit, don’t contribute to your credit utilization ratio, meaning they’re less impactful in this area.
How much does a personal loan affect your credit score?
The effect a personal loan has on your credit score depends on several factors. In the short term, you may see a small dip in your score after applying. However, in the long run a personal loan can help you build your credit if you make on-time payments by building your credit history and diversifying your credit mix.
Do personal loans hurt your credit?
Personal loans aren’t bad for your credit, but their impact largely depends on how you manage them. Here are a few ways a personal loan could hurt your credit score.
Missed payments. Missed or late loan payments can be reported to the credit bureaus which can have a negative impact on your score. Even if you have a lender that doesn’t report to the credit bureaus, your debt may be sent to a collection agency that does.
Over-applying. While the impact of a hard credit check is usually temporary, applying too to many places can have a negative impact. Frequent hard inquiries can signal financial uncertainty to lenders and can damage your score.
How does using a personal loan for debt consolidation affect your credit?
Debt consolidation is a common reason people take out a personal loan. It involves combining high-interest debt, like credit card debt, into a single loan with lower interest rates to help save money and simplify repayments. Here are a few things to consider and how debt consolidation affects your score.
Reduced credit utilization ratio. Your credit utilization has a big impact on your credit score. It measures how much available credit you have compared to your credit limit. You can help lower your utilization rate by using a loan to pay off your revolving credit accounts, which can help give your credit score a boost.
Lower interest rates. If you have excellent credit, it’s much easier to get approved for a loan with lower interest rates. However, if you don’t have good credit you may have fewer loan options available and another debt repayment strategy may be a better option.
What are other ways to build your credit without a personal loan?
A personal loan isn’t always the right answer. Depending on your personal finances, another credit-building strategy may be a better fit. Here are some ways you can build your credit score without taking out a personal loan.
Reduce your credit utilization ratio. Paying down the balance on your revolving credit accounts can have a big impact on your score. Explore different debt repayment strategies and find one that works for you.
Make timely payments. Many of your monthly payments can help you build a positive credit history. Paying a car loan, student loan, credit cards and in some cases your rent can help you build up your credit profile.
Open a secured credit card. If you have a limited credit history or poor credit, consider opening up a secured credit card. It works the same as a regular credit card except it requires a deposit to act as collateral. Using it responsibly and making the payments on time can help you build your credit.
Increase your credit limit. Requesting a high limit on your credit card or line of credit can help you lower your credit utilization ratio. However, for this to be effective you’ll have to resist the temptation to spend more on your card.
Monitor your credit report. Regularly checking your credit report can let you see your progress and motivate you to keep going. It can also help you catch errors and identify fraud early. Fixing inaccurate credit reports can help give your score a boost.
Final Thoughts
A personal loan can affect your credit in many different ways. Be sure to research your lender so you understand how everything, from the application process to repayment, can affect your credit score. Keep in mind, the effect a personal loan has on your credit score depends largely on how you manage it. Careful repayment and a diverse credit mix can help you build your credit score and overall credit health in the long run.
DISCLAIMER: This content is for informational purposes only and should not be considered financial, investment, tax or legal advice.
