How Do Personal Loans Affect Your Credit Scores?
Personal loans can help meet a variety of financial needs and there’s a lot to consider before applying one. Aside from comparing interest rates and loan terms from different lenders, it’s also important to think about how a personal loan could affect your credit scores.
Similar to credit cards, car loans or other types of debt, personal loans can show up on your credit reports. Before getting a personal loan, it helps to understand how it could help (or potentially hurt) your credit score.
Personal Loans and Credit Score Calculations
Credit scores measure how responsible you are when it comes to borrowing money and managing your finances. FICO credit scores, the scores used by 90% of top U.S. lenders, are based on five key factors:
- Payment history (35% of your score)
- Credit utilization (30% of your score)
- Credit age (15% of your score)
- Credit mix (10% of your score)
- Inquiries for new credit (10% of your score)
So where do personal loans fit into the credit scoring picture? Personal loans are installment loans, meaning that you borrow a lump sum of money and pay it back over time. Taking out a personal loan can impact each of the five FICO credit scoring factors.
How a Personal Loan Can Help Your Credit Score
Personal loans could help you to build positive credit history when used responsibly.
Consider the importance of payment history in FICO credit scoring. Paying your bills on time can help your score, while paying late or missing payments altogether can hurt it. If you get a personal loan and pay on time each month consistently that could carry a lot of weight in credit score calculations.
Personal loans can also have a positive impact on credit scores if you’re using them for debt consolidation. After payment history, your credit utilization or the amount of available credit you’re using is the second-most important credit scoring factor.
If you use a personal loan to consolidate high interest credit card debt, that can reduce your credit utilization ratio for those cards. Assuming you don’t charge any new balances to the cards, shifting the debt to a personal loan could give your score a boost.
Personal loans can also help with diversifying your credit mix, which counts for 10% of your FICO credit score. Lenders want to see that you know how to use different types of credit responsibly so a personal loan can help to balance things out if you’ve only ever had credit cards in your name.
How a Personal Loan Could Hurt Your Credit Score
When you apply for a personal loan, lenders typically perform a hard pull of your credit score. Each hard pull shows up as an inquiry on your credit report, potentially trimming a few points off your credit score.
Applying for a personal loan could hurt your score if you’re applying for loans with multiple lenders. Too many applications for loans could send the signal that you’re struggling financially and are desperate to borrow money. But if you’re only applying for a single personal loan, the credit score impact is usually minimal.
The biggest thing to watch out for with a personal loan is late or missed payments, since payment history is central to credit scoring. If a lender reports a late payment to one or all three of the credit bureaus, that can ding your credit score in a major way. Late payments and other negative credit history associated with a personal loan can stay on your credit report for up to seven years.
Maintaining Good Credit With a Personal Loan
Personal loans can be helpful when you need money to consolidate debts, cover medical expenses, fund a home renovation or just pay the bills if you’ve hit a rough spot financially. But it’s important to keep your credit score in sight and take steps to protect your credit history while borrowing.
Here are a few tips that can help you keep your credit score moving in the right direction when taking out a personal loan.
- Compare rates and terms carefully. Applying for the first personal loan you find can be a mistake if the loan carries a high APR or steep fees. Take time to shop around for personal loans that fit your budget and needs.
- Watch out for hard credit pulls. Typically, lenders won’t pull your credit until you apply for a personal loan. But if you’re shopping for free rate quotes, check to make sure that only a soft pull is required, which won’t show up on your credit history.
- Only borrow what you need. Taking on too big of a loan could result in monthly payments that are difficult to manage. So before applying, make sure you know how much you need to borrow. Using an online loan payment calculator can give you an idea of what your payments may look like if you’re approved.
- Set up automatic payments. Once you’re approved for a loan, consider setting up automatic payments from your bank account. This can help you avoid paying late. If you can’t pay automatically, scheduling due date reminders is another way to keep track of when loan payments are due.
Finally, remember to check your credit reports regularly to make sure your loan payments and account activity are being reported properly. If you spot an error that could negatively affect your credit score, reach out to the credit bureau that’s reporting the information to dispute it.
How to Use Personal Loans
What to know about personal loans, credit scores, and they can help you to pay off debt and more.
Rebecca Lake is a freelance writer specializing in personal finance,
credit and debt. She’s a contributor to U.S. News and World Report,
Forbes Advisor and The Balance and her work has appeared online at CreditCards.com,
Money-Rates.com and dozens of other top publications.