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How Does a Personal Loan Affect Credit Score?
Key takeaways
- A personal loan can help you build credit through making consistent on-time payments, improving credit mix, and lowering your credit utilization ratio
- Applying could cause a small, temporary dip in your credit score due to hard inquiries and a new account lowering your average credit age
- Potential risks include the possibility of missing payments and the addition of new debt. Borrow only what fits your budget and consider rate-shopping tools
If you are looking for a loan, you might also be thinking about how a personal loan could affect your credit score. After all, a credit score has a big influence over your ability to get credit and favorable loan terms. In addition, prospective employers, landlords, insurance agencies, and utilities might also consider your credit score as you work with them.
The good news is that if you manage it properly, a personal loan can have a positive effect on your credit score. Making all your payments on time is generally a major part of your credit score. A personal loan gives you an opportunity to build up your record of on-time payments.
There could be negative impacts, as well, so it's important to fully understand the relationship of personal loans and credit scores.
Can a personal loan help your credit score?
When managed carefully, a personal loan can support your credit health in a few meaningful ways.
1. On-time payments strengthen your payment history
Payment history is generally one of the most significant of all credit score factors. It accounts for 35% of the most commonly used FICO® Score. Each on-time payment you make adds to a positive personal loan payment history.
Automatic payments can be very helpful in making sure you don't accidentally miss a due date.
2. A personal loan can improve your credit mix
Credit scoring models often take into account the variety of credit types you carry, a factor sometimes referred to as "credit mix." This makes up 10% of the most common FICO® Score.
If your credit profile currently consists of credit cards, a form of revolving debt, you could broaden your credit mix with a personal loan, which is a type of installment loan.
3. Lowering credit card balances can boost your score
Let's look at how your credit utilization ratio and debt consolidation are related. Your credit utilization ratio shows what percentage of your available credit is being used. It can be a major part of your credit score—typically the second biggest factor.
Consumers often pay off high-interest-rate credit cards with a personal loan that offers a lower rate and a steady monthly payment. This can reduce your credit utilization ratio. It usually takes one or two months for your score to reflect this change.
How a personal loan might hurt your credit score
A personal loan also carries some potential risks to your credit, particularly in the short term or if not managed carefully.
1. Hard credit inquiries can cause a small drop
When you apply for a personal loan, lenders typically run a hard credit inquiry on your credit report to evaluate your application. This signals that you are in need of credit and could cause a small, temporary dip in your score.
You can minimize this personal loan credit inquiry impact by shopping with lenders who offer prequalification with a soft credit check. Lenders can get a general idea of your qualifications without it affecting your score.
In addition, many credit scoring models treat multiple inquiries as a single one—if you submit your applications around the same time, which is called a "rate shopping window."
2. Opening new credit may temporarily reduce your score
A new personal loan adds a new account to your credit report, which can reduce the average age of your accounts. Credit age is a small factor in most scoring models, and a lower average account age can cause a modest, temporary score decrease. This effect tends to diminish over time as the account ages and you build a positive payment history on it.
3. Missing payments can significantly hurt your credit
With every new loan comes the risk of a missing or late payment. Before taking out a personal loan, consider whether the monthly payment fits comfortably within your budget. Develop a plan that enables you to make every payment on time.
4. Higher overall debt can increase credit risk
As we said earlier, taking out a personal loan and credit utilization are connected. Adding new debt increases your total debt load, which can factor into how lenders assess your creditworthiness.
Does paying off a personal loan early help your credit?
The answer depends on what else is going on with your overall credit profile. Paying off a personal loan ahead of schedule could save you money on interest and reduce your debt load. That monthly payment is gone and you can put the money to some other use. However, the effect on your credit score is not always straightforward.
Closing an installment account could reduce the variety in your credit mix and lower the average age of your active accounts. Both of things could have a modest negative effect on your score in the short term.
You also have to weigh the possible effect on your credit card against other factors, including:
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Does the loan include a prepayment penalty?
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Where is the money coming from to pay off the loan early? Would it make more sense to pay down credit card debt with higher interest rates? Would it be more prudent to keep it as an emergency fund?
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Will you be applying for a mortgage or some other big loan in the near future? If so, even a small dip in your credit score could be costly if it affects the interest rate on that new loan
Should you take a personal loan to build credit?
Does a personal loan build credit? It can do that for some borrowers under the right conditions, especially if it is part of a broader financial strategy. In fact, some personal loans are designed to help people build credit.
When you take out a personal loan and make consistent on-time payments, you're establishing a positive payment history, which is one of the most important credit score factors. For borrowers who have limited credit history or who are working to rebuild after financial difficulties, this approach can be helpful.
A personal loan can also help diversify your credit mix, which could moderately boost your score. And if you use the loan to pay down high-interest credit card debt, the resulting reduction in your credit utilization ratio could boost your score.
Of course, if you're unable to make payments, the damage to your credit could outweigh any potential benefit. Another option is a secured credit card, which you back with a cash deposit and can use to build credit.
FAQs
A personal loan may help build credit under the right circumstances. Your on-time payment history is typically the most heavily weighted of all credit score factors. Making all you personal loan payments on time builds a positive history. A personal loan can also diversify your credit mix if your current accounts are limited to credit cards and could improve your credit utilization ratio, if you use the loan to consolidate credit card debt.
The impact also depends on your existing credit profile.
A hard inquiry on a personal loan application typically causes a small, temporary drop in your credit score (often just a few points). For most borrowers, the effect is minimal and tends to fade within a few months.
The impact can vary depending on your overall credit profile. Borrowers with limited credit history may feel the effect slightly more than those with established records. If you're rate shopping and apply to multiple lenders within the rate shopping window, it may be treated as a single inquiry by many scoring models. This minimizes the impact on your score.
Yes, missing even a single payment could impact your credit score.
When a payment is 30 days past its due date, a creditor may report it to one or all of the three credit bureaus—Experian™, TransUnion®, and Equifax®. At that point, the late payment may affect your credit score and could stay on your credit report for about 7 years.
The impact will vary according to the amount of the payment, how long it takes for you to make good on the account, and your credit history.
If you make a late payment before reaching the 30-day point, it probably won't be reported to the credit bureaus. You might, however, be hit with a late-payment fee or penalty interest rate.
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