Do Personal Loans Help Or Hurt Your Credit Score?
Hanna Kielar7-Minute Read
July 19, 2022
Anytime 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 need a personal loan but are worried about it affecting your credit score. Will taking the loan out now affect your ability to get another loan, or a mortgage, later? While a personal loan will affect your credit, the nature of its impact can vary.
Let’s look at how personal loans can influence your credit in both positive and negative ways.
Why Do Personal Loans Affect Your Credit?
When you apply for and receive a personal loan, your lender will report it to the major credit bureaus: ExperianTM, TransUnion® and Equifax®. This is no different than any other type of financing.
As you pay back the loan in installments per your repayment terms, your progress will be reported to the credit bureaus. Your credit score could increase if you make on-time monthly payments, but your score would likely suffer if you miss payments.
How Do Personal Loans Help Your Credit?
With a personal loan, you’re borrowing a lump sum of money all at once, then making regular monthly payments until you’ve paid it all back, plus interest. This is in contrast to 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, as you would with a credit card.
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. A solid history of full, on-time payments will account for roughly 35% 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 to build credit, though it isn’t always wise.
Installment debt can go a long way in making – or breaking – your score. With an installment debt, you make payments every month over a period of months or years. This helps increase the length of credit history, which lenders can later evaluate.
Diversifying Your Credit Mix
Your credit mix is how many types of accounts you have. These may include credit cards, personal loans, mortgage loans and the like. Lenders prefer to see that you can handle different types of credit – specifically, installment and revolving.
A personal loan on 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 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. That’s because installment debt, like personal loans, doesn’t factor into your credit utilization ratio.
Consolidating Your Debt
Using a personal loan for debt consolidation can likewise give your credit score a lift.
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 seek a personal loan so you can 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, 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 but later max them out again, you aren’t addressing the root of the issue.
How Do Personal Loans Hurt Your Credit?
Let’s review some ways a personal loan could end up hurting your credit.
Missed Or Late Payments
Perhaps it goes without saying that your credit score will suffer if you don’t keep up with your loan payments.
Your payment history shows how often you’re making on-time payments on your debt, and this history 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 a lot – and the delinquent account will be noted on your credit report.
Whenever you apply for a new credit account of any kind, the lender will pull your credit report, resulting in a hard inquiry that causes a small, short-lived dip in your credit score.
When applying for installment loans, such as a personal loan, consumers commonly shop around with multiple lenders in hopes of finding the best deal. This is known as getting prequalified, and it may involve a soft credit check. A soft credit check won’t affect your credit score, but multiple soft credit pulls within the span of a few weeks could be viewed as a single hard inquiry.
Paying Off The Loan
A personal loan also could potentially hurt your credit, at least temporarily, when you finish paying it off.
When you close a personal loan account, your credit score can sometimes take a small hit. This isn’t because you’ve done something wrong, but it’s 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 can reduce 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. This can be good news if you managed the account well and always kept up with payments.
Debt accounts in good standing when they are paid off can remain on your credit report for up to 10 years after being closed, giving you a positive credit boost as long as they stay there.
Charged-off or delinquent debt – accounts you were late on or accounts 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 with time, 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. It can cover an emergency repair, fund a remodel you hope will increase the value of your home, consolidate high-interest debt or pay for just about anything else for which you might need 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 pursue this option. If you have low credit already and wouldn’t qualify for a good interest rate, a personal loan could do more harm than good. If your credit is in good or great standing, 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 personal finances and whether your budget can handle the structured, monthly payments on the new loan. Do your research, evaluate your situation and make sure that a personal loan is the best option for you. The more confident you feel about your finances when taking on the debt, the more you can enjoy the positive side to this type of financing.
When you’re ready to apply for a personal loan, get started with Rocket LoansSM.
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