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A personal loan can both positively and negatively affect 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 personal loans can help your credit score
A personal loan could have a positive impact on your credit score in these situations:
You make on-time payments. Payment history is the most important credit score factor. Making monthly loan payments builds a positive payment history, which helps your credit score over time.
Paying a few days late may not affect your credit, but lenders can report payments that are 30 days late or more to the credit bureaus, leading to notable damage to your credit score.
You use the loan to consolidate credit card debt. Using a personal loan to pay off credit card debt frees up revolving credit and lowers your credit utilization, or the percentage of open revolving credit you’re using. Utilization is the second-most important credit score factor.
You use the loan to avoid racking up additional credit card debt. If you need to choose between a personal loan vs. a credit card for a large 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. A personal loan is a type of installment credit, and 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.
How personal loans can hurt your credit score
A personal loan can also hurt your credit score in a several ways:
You face a hard inquiry when applying. Many lenders allow you to pre-qualify for a personal loan with a soft credit check, which won’t affect your credit score.
However, formally applying for a personal loan triggers a hard credit check, which is a more thorough evaluation of your credit history and 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.
You shorten your credit age. A new loan may also shorten the average age of your total credit history. Length of credit history represents 15% to 20% of your 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 many 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.
Frequently Asked Questions
Are personal loans bad for your credit score?
You may see your credit score drop by a few points after getting a personal loan due to the hard inquiry, however, a personal loan isn’t necessarily bad for your credit score. In fact, it could be good for your credit if you make on-time payments and use the loan to consolidate credit card debt.
Will my credit score drop if I pay off a personal loan?
Paying off a personal loan could cause your credit score to drop, but the effect is only temporary. Reducing debt frees up room in your budget and lowers your debt-to-income ratio, both of which are good for your finances.
Do all personal loans appear on your credit reports?
Personal loans from most banks, credit scores and online lenders will appear on your credit reports. Other types of loans, like payday loans and title loans, don’t report to the credit bureaus, so they won’t appear on your credit reports.
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