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When you apply for lending products, your credit score may dip slightly. Personal loans are no exception to the rule — applying for one can ding your credit score — at least temporarily.
But there’s an upside: making timely monthly payments can also mean good news for your credit score over time. Your payment history, which is the largest component of your credit score, will improve. Your credit utilization will also decrease which benefits your overall credit health.
Do personal loans build credit?
Personal loans help your credit in three ways: by boosting your payment history, adding to your credit mix and lowering your credit utilization ratio. These factors make up 75 percent of your score.
How loan applications impact your credit
- When you apply for a personal loan, lenders will assess your credit score and history to determine your creditworthiness and financial health. They do this by running a hard credit check.
- Lenders also allow you to check the terms and rates you may be eligible for by doing a soft credit check, which has no impact on your credit score. That said, not all lenders offer this option and you will still have to go through a hard credit check if you decide to apply for the loan.
- Hard credit checks temporarily lower your credit score by as much as 10 points.
- If you have excellent credit, applying for a loan will most likely make your score drop by five points or less.
- Your credit score will typically recover within a few months, but the hard credit check will stay on your credit report for up to two years.
Since applying for a personal loan requires a hard credit check, it is a good idea to be as prepared as possible to limit any potentially negative credit implications. You are required to submit additional documents when you apply for a personal loan, including proof of identity, employer and income verification and proof of address. Have these ready and on-hand before applying to ensure a smoother process.
How personal loans could help your credit
Under the correct circumstances and when used responsibly, a personal loan can positively impact your credit score in a few ways:
- Better credit mix: Adding various types of lending products to your portfolio helps keep your credit score high as long as you stay on top of payments. It is generally a good idea to have a mix of installment loans and revolving credit, as credit mix accounts for 10 percent of your FICO score.
- Debt consolidation: If you use a personal loan to consolidate debt, you can generally take advantage of lower interest rates than you’d get with credit cards. With a lower interest rate, you may be able to pay down outstanding debt faster, which will improve your credit score.
- Payment history: A personal loan can help establish a positive payment history when made in full and on time. Positive payment history makes up 35 percent of your FICO score, the largest category in determining your score.
- Reduced credit utilization ratio: A personal loan does not affect your credit utilization ratio, but using that loan to pay off revolving credit card debt could lower your ratio. You generally want to keep your credit utilization below 30 percent.
How personal loans could hurt your credit
While personal loans could help you improve your credit score, they can also hurt your score if you’re not prepared to pay them off. Here are some risks you need to consider before applying for a personal loan:
- Hard inquiry on your credit: Due to the hard credit check, you will likely see a short-term drop in your credit score when you formally apply for the loan. While this may not be detrimental to your long-term credit score, it could cause some harm to your credit if you apply for multiple loans in a short time.
- Monthly payments: Before applying for a loan, you should analyze your monthly expenses to see if it is within your budget to add another monthly payment to your expenses.
- More debt: While all debt isn’t necessarily negative, it’s important to analyze your current financial situation before applying to determine if a loan is a move in the right direction. Taking on more debt than you can afford can lead to late or missed payments, both of which can have long-lasting effects on your credit and ability to access other lending products in the future.
- Potentially high interest rates and fees: Depending on your creditworthiness, you could get stuck with interest rates as high as 36 percent, in addition to other fees. If you’re unsure you’ll be able to afford the rates you’re offered in the long term, you risk falling behind on payments which can damage your credit and cost you thousands in interest.
Here are some of the events that could occur during the life of your loan that would hurt your credit score.
|Event||Average time on credit report|
|Late payments||7 years|
|Debt collections||Up to 7 years|
|Chapter 13 bankruptcy||7 years|
|Chapter 7 bankruptcy||10 years|
Missing payments, defaulting on loans and bankruptcy all stay on your credit report for approximately seven years, if not more. When you miss a payment, it is sent to collections and if this happens your credit score could drop up to 90 to 110 points.
If you do not make the late payment within 30 days, the lender can report the defaulted payment to the credit bureau. While some lenders wait up to 60 days, making the payment as soon as possible is best.
What to consider before taking out a personal loan
Before taking out a loan, consider the benefits and drawbacks of adding another monthly bill to your budget. A few things to think about are:
- Reason for the loan: Personal loan lenders tend to offer different interest rates depending on the purpose of your loan. For instance, personal loans to consolidate debt have a much lower interest rate compared to one used to finance a vacation.
- Your credit score and history: Do you have a good credit score and healthy habits with your credit? If not, you can take steps to improve your credit score by restoring some of those bad habits.
- Your debt-to-income ratio: Your debt-to-income ratio, or DTI, measures your monthly debt relative to your monthly income. Generally, the higher the DTI ratio, the less likely you will qualify for a loan. To calculate your DTI ratio, you can use Bankrate’s debt-to-income ratio calculator.
- All of your options: Shopping around for the best personal loan for you is one of the most important steps to take. Each lender offers different rates, fees and conditions. The best way to find out how much you’d be paying every month is to explore all of your options, especially if you have less-than-perfect credit.
The bottom line
Personal loans can be a great tool that can help you improve your credit score, consolidate credit card debt or pay off major expenses. However, knowing how applying for a loan can affect your credit score is important.
While you may experience a short-term dip when you submit your application, you could improve your credit score over the long run by making timely payments and using your loan funds to pay down existing debt. Finally, before you apply, make sure to shop around for rates and crunch the numbers to ensure you get the best terms and rates for your situation.