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When you apply for debt products, your credit score may dip slightly. Personal loans are no exception to the rule — applying in hopes of getting approved for the funds you need can ding your credit score.
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 decrease, which also benefits your overall credit health.
How loan applications impact your credit
When you apply for a personal loan, lenders will assess your credit score and history to determine your credit risk or creditworthiness. To do this, lenders run a hard credit check. When they run this check, they’re looking for indicators of financial health, like low credit balances and a good debt-to-income ratio.
A hard credit check will temporarily lower your credit score by five points or less. Your score will likely drop less than that if you have excellent credit. Your credit score will typically recover within a few months, but the hard credit check will stay on your credit report for two years.
Since applying for a personal loan requires a hard credit check, it is a good idea to be as prepared as possible. You are required to submit additional documents when you apply for a personal loan. These typically include proof of identity, employer and income verification and proof of address.
How personal loans could help your credit
Under the correct circumstances and when used responsibly, a personal loan can positively affect your credit score in a few ways:
- Better credit mix: Adding various types of credit 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.
- 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: Every time you borrow money, you increase your chances of falling into debt— especially if you continue to rack up credit card balances while paying off your loan. While not all debt is 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.
- Potentially high interest rates and fees: Depending on your creditworthiness, you could get stuck with a considerably high interest rate and fees. The higher the interest rate, the longer you may be paying off the loan. If you can’t afford those rates in the long term, you risk falling behind on payments and damaging your credit score.
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|
As illustrated above, missing payments, defaulting on loans and bankruptcy all stay on your credit report for approximately 7 years, if not more. When you miss a payment, it is sent to collections. 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: Are you interested in a personal loan to pay for a vacation or a luxury item? If this is the case, consider whether it makes more sense to save up for the item than apply for a loan. Depending on the purpose of your loan, you may also want to consider other types of loans. If you are taking out a loan for home improvement purposes, a home equity loan could have better rates and fit your needs well.
- 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.
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.