How Does A Personal Loan Affect Your Credit Score?

November 22, 2022 Personal Loans
How Does A Personal Loan Affect Your Credit Score?

How Does A Personal Loan Affect Your Credit Score?

If you need emergency cash but can’t use your credit card, a low-interest personal loan may be the solution. Personal loans are becoming increasingly popular because they can be used for a wide range of purposes – and often with competitive rates and lengthy repayment terms. But, you should know precisely how a personal loan impacts your credit score before applying.

What Is A Personal Loan?

A personal loan is money a consumer borrows from a bank, or other lender, to pay for a personal expense. Personal loans are a type of installment debt, so funds are issued as a lump sum and repaid over time. Unlike most other installment loans, like student loans or mortgage loans, personal loans can be used for anything. For example, personal loan proceeds can be used to cover:

  • Medical bills
  • Home renovations
  • Debt consolidation
  • Funeral costs
  • Vacation expenses
  • Moving costs

Keep in mind, however, that personal loans cannot be used to finance illegal activities, and some lenders may impose other restrictions. For example, it is common for lenders to prohibit the use of personal loans to cover secondary education expenses.

How Credit Scores Are Calculated

credit-score-computer

The Fair Isaac Corporation – or FICO – issues borrower credit scores that range from 300 to 850. To do so, FICO uses its proprietary credit score formula that is based on five components, each of which makes up a different percentage of a consumer’s overall score. Notably, personal loans directly or indirectly impact all five factors.

  • Payment history: Accounting for 35% of a consumer’s credit score calculation, payment history is based on whether the borrower’s past credit accounts were paid on time.
  • Outstanding debt amount: The amounts owed by a borrower on other loans and lines of credit make up 30% of their score calculation. This includes the consumer’s credit utilization ratio among other metrics.
  • Length of credit history: Having a longer, more established credit history can help improve a borrower’s credit score. However, this factor accounts for only 15% of the score calculation.
  • Number of open credit lines: Also referred to as credit mix, a consumer’s combination of outstanding debts determine 10% of their credit score calculation. In general, it’s best to have a mix of credit cards, installment loans, retail accounts, and other common types of debt.
  • New debt: Borrowers who frequently open new credit accounts are considered riskier to lenders. That said, the number of recent inquiries and new accounts only factors into 10% of a consumer’s FICO score.

How Can A Personal Loan Help Your Credit?

Not only do personal loans come with lower interest rates than credit cards, they can help improve your credit score. If you have enough cash flow to make regular, on-time payments, taking out a personal loan may strengthen your credit profile in several ways.

On-time Payment History

Paying your personal loans on time helps contribute to a good payment history, which accounts for 35% of your FICO score. Paying personal loans and other debts in full and on time informs creditors that you are more likely to pay other debts in a timely manner. As a result, you’ll have an easier time opening new credit lines in the future.

Personal loans are an especially good way to improve your credit score if you just started building or improving your credit. In fact, many online lenders even provide personal loans that are tailored to people with bad credit – or no credit at all.

Diversified Credit Mix

Taking out a personal loan improves your credit mix, or the number and combination of your outstanding debts, contributing 10% to your credit score calculation. You don’t need a massive number of debts to have a good credit mix – or even one of each type – but a personal loan can help demonstrate your experience with installment loans.

A diverse credit mix also conveys your creditworthiness to lenders and increases your approval odds for future credit, like a mortgage or car loan. That said, a diverse credit mix can backfire if you have high outstanding balances on your credit lines.

Low Credit Utilization Ratio

Because personal loans are an installment debt, opening a new account and making payments does not directly impact your credit utilization ratio, which is the percentage of money you’ve borrowed from your total borrowing limit.

However, personal loans can indirectly improve your credit utilization ratio if you use them to replace high-interest revolving debt, like credit card balances, which directly affect your credit utilization ratio.

How Do Personal Loans Hurt Your Credit?

Just as personal loans can improve your credit profile, each new loan also has the potential to hurt your credit score. Personal loans may negatively impact your credit score in the following ways:

Hard Credit Inquiry

Lenders perform a credit check on you every time you apply for new financing, including personal loans. This means that taking out a personal loan results in a hard inquiry on your credit report, which reduces your credit score.

A single hard inquiry only remains on your credit report for two years, and usually only affects your score for one year. That said, multiple hard inquiries can cause significant damage to your overall credit health. To avoid these impacts, limit your credit applications and choose lenders that offer a prequalification process based solely on a soft credit check.

Late or Missed Payments

Late or missed payments negatively impact your payment history, which is 35% of your FICO score – the most impactful of any other metric. Because of this, your credit score could massively decline if you pay a bill late or miss payments entirely.

And, while the drop in score is more substantial for payments that are 60 or 90 days late, a late payment of 30 days or more can still impact your creditworthiness when it is reported to the major credit bureaus – Experian, Equifax, and TransUnion.

Cycle of Borrowing

Taking out a personal loan is great for paying off other higher-interest debt, but don’t make it a habit. Constantly using personal loans for debt consolidation creates a cycle of borrowing that leads to longer repayment terms and can hurt your credit score.

What’s more, borrowers who take out a personal loan to pay off maxed-out credit cards will likely charge more than they can afford on the credit card again and again. This is especially true for consumers who don’t address underlying issues with overspending before consolidating the debt.

When A Personal Loan Might Make Sense

Because personal loans have the potential to hurt and help your credit, there are a few scenarios where taking out a personal loan might make sense strategically. Consider a personal loan if you:

  • Want to consolidate high-interest debts: Personal loans usually have lower interest rates than credit cards, so you can use the former to pay off the latter and reduce the amount of interest you pay over time. Consolidating debt also improves your credit utilization ratio, so it may be worth taking out personal loans to pay off other higher-interest loans – if you’ll qualify for a lower rate.
  • Are faced with emergency expenses: If you’re faced with an expensive emergency, a personal loan can offer lower interest rates and more flexible spending than other lending options. That said, it can take three business days or longer for a personal loan to be approved and funded, so choose a lender that offers same-day funding or opt for a credit card.
  • Need to make home improvements: Personal loans are commonly used to finance home improvements and, unlike home equity loans or home equity lines of credit (HELOCs), do not require you to pledge your home as collateral. What’s more, home improvements can add to the value of your home and increase your home equity in the long run.
  • Want to pay for an event or trip: Because personal loans are so flexible, they can be used to pay for everything from weddings to family vacations. Think twice before using borrowed funds to cover a trip or other unnecessary expense, though. If you don’t pay off the loan quickly, interest will accrue and the overall cost of that vacation will rise.

How much does your credit score drop when you get a personal loan?

Applying for a personal loan costs most people a five-point credit score drop due to the hard credit pull. A hard inquiry only remains on your credit report for two years, and only impacts your score for one year.

How long does it take for a personal loan to show up on your credit report?

It normally takes 30 days from the close of the current billing cycle (or fewer) for a financial event to affect your credit report. Once on your credit report, adverse information remains there for seven to 10 years, depending on the event.

How can you use a personal loan?

You can use a personal loan for everything from paying off high-interest debt to financing a vacation or paying for a medical emergency. Personal loans also can be used to cover home improvements, events, and large purchases.

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