How Does a Personal Loan Affect My Credit?
A personal loan can act as a really useful financial tool. You can take one out to cover an emergency repair, to fund a remodel that you hope will increase the value of your home, to consolidate high interest debt, or for any other reason you may have for needing a large sum of cash.
A personal loan has the potential to help or hurt your credit, which can make it easier or harder for you to borrow money when you need it in the future.
Before taking on any kind of debt, it’s always a good idea to educate yourself on the ways debt can and will affect your credit history and credit score. So let’s take a look at how personal loans affect credit.
Personal Loans and Your Credit Score
Any time you take on debt, you’re using the past credit you’ve built up and staking your future credit on the successful management of that debt. Personal loans are no exception.
So, what exactly is a personal loan, and how does it interact with your credit rating?
Introducing Personal Loans
A personal loan is an installment loan. This means that you borrow a lump sum of money all at once, then spend a certain amount of time making regular payments until you’ve paid it all back, plus interest.
This is in contrast with a revolving loan, where you can continuously borrow against a line of credit, only paying interest on what you’ve borrowed and paying it off as you go (think credit cards).
This is an important distinction, as installment debt and revolving debt affect your credit score in slightly different ways.
Introducing Your Credit Score
Now, let’s go over the elements that make up your credit score and how installment debts such as personal loans factor into your score.
Your FICO® Score, the most commonly used credit score, is made up of a several different factors: payment history, amounts owed, length of credit history, credit mix and new credit.
Payment history, which shows how often you’re making on-time payments on your debt, is the most important factor in determining your FICO® Score. If you miss a payment on any of your credit accounts, even just once, your score will drop (potentially by a lot) and the delinquent account will be noted on your credit report.
This is why installment debt can go such a long way in making – or breaking – your score. With an installment debt, you make payments every month over the course of months or years. This helps to build a strong, proven history of on-time payments.
The second most important factor in determining your credit score is amounts owed. This largely refers to the utilization rate on any revolving credit accounts you have open. To get the best possible score, it’s recommended that you keep the amount of available revolving credit you use to a minimum. However, according to myFICO.com, how much you owe on installment loans may factor into this part of your score as well.
The three final pieces that make up your score – length of credit history, credit mix and new credit – are not as heavily weighted, but are still worth keeping an eye on.
Length of credit history refers to how long your credit accounts have been open, and mainly has to do with revolving accounts. Credit mix is how many different types of accounts you have, including credit cards, personal loans, mortgage loans and the like. Lenders like to see that you can handle different types of credit – specifically, installment and revolving. Finally, new credit covers whether you’ve opened a new account recently. While one new account isn’t a bad thing, multiple new accounts in a short period of time can make you look like a risk to lenders.
How a Personal Loan Can Help Your Credit
When used correctly, a personal loan can help you build good credit or improve your credit score.
As mentioned, having a solid history of making full, on-time payments makes up a big chunk of your credit score. By simply staying on top of your monthly payments, you’re paving the way for a good credit history.
Additionally, having a personal loan in your credit report gives you a more diverse credit mix. If the only credit accounts you have open are credit cards, adding an installment loan like a personal loan to the mix can give you a boost to your score.
A personal loan can also help boost your score in an indirect but significant way. If you have a lot of credit card debt, you probably have a pretty high utilization rate. Since credit utilization is such a big factor in determining your credit score, using a personal loan to pay off your credit card debt can significantly increase your score because installment debt like personal loans don’t factor into your utilization rate.
Aside from lowering your utilization, why might someone use a personal loan to pay off their credit card debt? The answer is debt consolidation.
Let’s say you have several credit cards with high interest rates and balances so large that you’re having trouble making more than the minimum payments each month. In this situation, it might make sense to take out a personal loan to combine and pay off all your credit card debt, trading in the high interest of your multiple credit card payments for a single monthly payment with a lower interest rate (personal loans tend to come with lower rates than credit cards).
Keep in mind, however, this tactic only works if you’re committed to reducing your credit card debt in the long term. If you use a personal loan to pay off your credit cards just to max them out again, you aren’t addressing the root of the issue.
How a Personal Loan Can Hurt Your Credit
Obviously, if you don’t keep up with your loan payments, it’ll hurt your credit score. But what are some other ways a personal loan can hurt your credit?
First, any time you apply for a credit account of any kind, the lender will pull your credit report, resulting in a hard inquiry. A hard inquiry causes a small, short-lived dip in your credit score; it should bounce back fairly quickly. When applying for installment loans like a personal loan, it’s common for consumers to shop around with multiple lenders to try to get the best deal. If you do this within the span of a few weeks, multiple credit pulls will generally be viewed as a single hard inquiry.
Another way a personal loan could potentially hurt your credit, at least temporarily, is when you finish paying it off.
When you pay off and close an installment loan account, your credit score can sometimes take a small hit. This is not because you’ve done something wrong (remember, paying off a debt is something to feel proud of!), but because you’re closing an account that was actively having a positive effect on your score. A well-handled closed account can have a positive impact on your score as well, but it won’t have as much of an effect as an open account. You may also suffer a slight dip because, with the closing of the account, you’re making your credit mix less diverse.
Don’t worry about these small ups and downs too much. In time, your credit will adjust to the changes and return to its original number, or even higher (provided you keep up with your other credit accounts in a timely manner).
How Long Can a Personal Loan Affect My Credit?
Even after you’ve paid off your personal loan, the account will stay on your credit report for years after it closes. This is good news if you managed the account well and always kept up with payments.
Debt accounts that were in good standing (meaning you made your payments in full and on time, every time) when they were paid off can stay on your credit report for up to 10 years after the accounts were closed, giving you a positive credit boost as long as they stay there.
Delinquent or charged-off debt (i.e. accounts you were late on or accounts that got sent to collections) can only stay on your credit report for seven years after the account was first reported as delinquent. However, the negative effects of the late or missed payments will likely begin to fade as time goes on, even before the account gets removed from your credit report.
Using a Personal Loan to Build Credit
It’s possible to use a personal loan solely for the purpose of building up your credit history and credit score, though it isn’t always advisable.
If your credit isn’t great, you may have a hard time getting a loan with a good rate. And, if you aren’t sure of your ability to repay the loan, you could end up making your situation worse if you find yourself unable to fulfill your monthly payments.
And if you want to work on building your credit, getting a credit-builder loan from a credit union or opening a secured credit card might be a better option.
Things to Consider Before Taking Out a Personal Loan
Before taking on debt, it’s important to consider your overall financial situation and whether your budget can handle the structured, monthly payments on the new loan.
Do your research, evaluate your situation and make sure that taking out a personal loan is the best option for you. The more comfortable you feel financially when taking on the debt, the more likely you’ll be able to avoid the personal loan negatively affecting your credit.
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What Credit Score Do You Need for a Personal Loan?
Wondering what credit score you need for a personal loan? Read our article for a background on good credit and the effects of credit on personal loan approval.