How Does a Personal Loan Affect Your Credit Score?
A personal loan can build your credit scores in the long term as long as you consistently repay the debt on time.
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A personal loan can have both positive and negative influences on your credit score. If you make on-time payments and use the loan to reduce your credit card debt, your score will likely benefit. But a personal loan could also hurt your credit, particularly if you miss payments.
How a personal loan affects your credit score
There are a few different ways a personal loan can affect your credit score, including:
Applying for a loan. Many lenders allow you to pre-qualify for a personal loan with a soft credit check, which is a routine check of your creditworthiness. A soft inquiry won’t affect your credit score and allows you to shop for the best rates and terms.
Formally applying for a personal loan triggers a hard credit check, which is a more thorough evaluation of your credit history. The inquiry usually knocks a few points off your credit score. A hard inquiry can stay on your credit report for up to two years but only affects your score the first year.
Making payments. Payment history is the most important credit score factor. Making loan payments on time can build your score, while missed payments will hurt your score.
Making a payment a few days late may not affect your credit, but lenders can report payments that are more than 30 days late to the credit bureaus, leading to notable damage to your credit score.
Credit utilization. Your credit utilization ratio, or the percentage of your open revolving credit you’re using, is the second-most important credit score factor. Experts often recommend keeping this number below 30% to maintain a healthy credit score.
A personal loan is a type of installment credit, so it doesn’t directly impact your credit utilization. However, using a personal loan to pay off credit cards with high balances would lower your credit utilization, which helps your credit score.
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Could a personal loan help your credit score?
A personal loan could have a positive impact on your credit score in some situations:
You make on-time payments. Making monthly loan payments helps you build a positive payment history, which helps your credit score over time.
You use the loan to consolidate credit card debt. Using a personal loan to consolidate credit card debt frees up revolving credit and lowers your credit utilization, which is good for your credit score.
You use the loan to avoid racking up additional credit card debt. If you need to choose between a personal loan vs. credit card for an emergency or unexpected expense, using a personal loan will generally have less impact on your score because it doesn’t affect your credit utilization.
You diversify your credit mix. Having several different types of credit — such as installment loans, credit cards and a mortgage — benefits your credit score. If you don’t have any other installment loans, a personal loan will diversify your credit mix, which could give your score a bump.
Could a personal loan hurt your credit score?
A personal loan can also hurt your credit score in a few ways:
Initial hard inquiry. The hard inquiry that’s required when you apply for a personal loan will appear on your credit reports and typically drops your score by a few points.
Shortening your credit age. A new loan may also shorten the average age of your total credit history. Length of credit history represents 15% of your FICO score, and a longer credit history is considered better than a shorter one.
You miss loan payments. Missing personal loan payments by more than 30 days will usually hurt your credit score, especially if you default on the loan. You can also hurt your credit score if you co-sign a personal loan for someone who misses payments.
You rack up more debt as the result of the loan. Getting a personal loan for debt consolidation and then charging up your newly paid-off credit cards again could hurt your credit score and overall finances.
You pay off the loan. You may see your credit score drop temporarily when you pay off a personal loan. This may occur because your average credit age drops (if the loan was one of your older accounts) or your credit mix changes (if you don’t have other installment loans). Seeing your score tumble can be frustrating, but the dip is usually short-lived.
How to use a personal loan to improve your credit
Managing a personal loan responsibly can help you improve credit over time. Follow these tips to build good credit using a personal loan.
Avoid applying for lots of loans in a short window. A single hard inquiry usually only dings your score by a few points, but the effect of multiple hard inquiries within a short period can add up. Avoid applying for multiple loans and credit cards within a short window to minimize the impact.
Make sure payments fit within your budget. If payments would stretch your budget, you may need to reconsider taking on a personal loan. You risk missing payments or having to take on additional debt if your loan isn’t affordable.
Set up automatic payments. Automating debt payments for at least the minimum amount due can help you avoid missing payments and build a positive track record.
Be strategic about how you use the loan. A loan can improve your credit score when you use it to pay off credit card debt, and it could save you money on interest, as well. But be cautious about using a personal loan for discretionary spending, like a wedding or vacation, as it will increase your debt.
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