How Do Personal Loans Affect Your Credit Score?
7-Minute ReadApril 12, 2022
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.
Let’s say you want to take out a personal loan but are worried about it affecting your credit score. Will taking the loan out now affect your ability to take out another loan later, or a mortgage? While the act of taking out a personal loan will affect your credit, the nature of its impact can vary.
This article will explain how personal loans can affect your credit, in both positive and negative ways.
How A Personal Loan Can Help Your Credit
When you take out a personal loan, you’re borrowing a lump sum of money all at once, then spending a certain amount of time making regular monthly 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, like with credit cards.
Personal loans and other forms of installment debt can do a lot to benefit your credit score. Let’s take a look at how.
Building And Improving Your Credit Score
When used correctly, a personal loan can help you build or improve your credit score. Having a solid history of making full, on-time payments can make 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. It's possible to use a personal loan solely for the purpose of building up your credit, though it isn't always advisable.
Installment debt can go 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.
Diversifying Your Credit Mix
Your 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.
Having a personal loan in your credit report can give you a more diverse credit mix. If the only credit accounts you have open are credit cards, adding a personal loan to the mix can give your credit score a boost.
Lowering Your Credit Utilization
A personal loan can also help raise 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 doesn’t factor into your utilization rate.
Consolidating Your Debt
Using a personal loan for debt consolidation can also help give your credit score a boost.
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, as personal loans tend to come with lower rates than credit cards.
Keep in mind, however, that 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 Taking Out A Personal Loan Can Hurt Your Credit
Let’s take a look at some ways a personal loan could end up hurting your credit.
It may go without saying that, if you don’t keep up with your loan payments, it’ll hurt your credit score.
Your payment history shows how often you’re making on-time payments on your debt and 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 can drop – potentially by a lot – and the delinquent account will be noted on your credit report.
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.
When applying for installment loans, such as a personal loan, it's common for consumers to shop around with multiple lenders to try to get the best deal. This is known as getting prequalified, and may involve a soft credit check, which won’t affect your credit score. If you do this within the span of a few weeks, though, multiple soft credit pulls could be viewed as a single hard inquiry.
Paying Off The Loan
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 a personal loan account, your credit score can sometimes take a small hit. This is not because you've done something wrong, 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.
How Much Can A Personal Loan Affect Your Credit Score?
A hard inquiry by itself can hurt your credit score by up to 10 points, even if you’re not approved for the loan in the end. If you miss a payment on your loan, even just once, your score could drop by up to 80 points.
Even after you've paid off your personal loan, the account will stay on your credit report for years after it closes. This can be good news if you managed the account well and always kept up with payments.
Debt accounts that were in good standing 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 – meaning accounts you were late on or accounts that got sent to collections – can only stay on your credit report for 7 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.
Should You Take Out A Personal Loan?
A personal loan can be 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 just about any other reason you may have for needing a large sum of cash.
Getting a personal loan can affect your credit in numerous ways, though, as you’ve seen, and it’s important to weigh those effects when deciding whether to take out a loan or not. If you have low credit already and wouldn’t qualify for a good interest rate, taking out a personal loan could do more harm than good. If your credit’s in good or great standing, then getting a personal loan may even improve it in the long run.
Keep in mind, also, how personal loans can affect your credit if you’re thinking about getting a mortgage in the future.
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 confident you feel financially when taking on the debt, the more likely you'll be able to avoid the personal loan negatively affecting your credit.
If you feel confident a personal loan is right for you, get started today with Rocket LoansSM.
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