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- Personal loans can be both good for and detrimental to your credit score, depending on how they are handled.
- Personal loans can boost your credit score by adding to your credit mix, improving your credit utilization and your payment history.
- Applying for a personal loan can hurt your credit score temporarily by adding to the amount owed portion of your credit score, and missing payments can lower it further.
When you take out a personal loan, you will likely see your credit score drop by a few points. That is because you are lowering the average age of your open accounts and adding to the total amount you owe — both of which impact your credit score. The application itself also creates a temporary drop in your score of up to 10 points because the lender will do a hard pull of your credit.
However, both of these drops are temporary and often don’t outweigh the potential benefits of taking out a personal loan for expenses like debt consolidation, home remodeling or emergency expenses.
How do personal loans affect credit score?
Debt from any sort of credit product can negatively impact your credit, and a personal loan is no different. But, if handled properly, personal loans can also be beneficial for your credit.
Positive effects of personal loans on credit
A personal loan can benefit you by adding to your credit mix and improving your payment history. If used to consolidate debt, it can also help with your credit utilization ratio.
- Payment history. Your ability to pay on time accounts for 35 percent of your FICO score — the largest portion. Consistent, on-time payments on your personal loan will increase your score over time.
- Credit mix. Credit mix — or the diversity of your accounts — is 10 percent of your FICO score. If you have two credit cards, for example, a personal loan would expand your credit mix and could help improve your score.
- Credit utilization ratio. Using a personal loan to consolidate credit card debt can improve your credit utilization ratio, which makes up 30 percent of your FICO score. That is because credit utilization measures how much of your available credit is compromised by revolving debt.
Negative effects of personal loans on credit
A personal loan may lower the total age of your accounts and increase the amount owed portion of your credit – both of which can lower your score.
- Missed payments. The same way on-time payments can boost your score, if a lender reports late or missed payments to the credit bureaus, this can lower your credit for up to seven years.
- Amount owed. When you take out a personal loan, the amount owed portion of your credit also increases. This may cause you to see a slight dip in your score.
- Hard inquiry. Any time you apply for a loan, lenders will run a hard credit pull. This will temporarily drop your score by as much as 10 points. However, your score should go up again in the following months after you start making payments.
How credit score affects your overall financial health
Your credit score is a measure of how well you handle your financial accounts. This, in turn, allows lenders to make a decision about whether or not they can take on the risk of lending you money, that’s why the higher, the better.
Additionally, insurers, employers and landlords can use your credit as a touchstone for reliability in some states. A score in the 300 to 579 range, considered poor by FICO, might keep you from being approved for your dream home or a line of credit to purchase a big-ticket item.
In its simplest form, a strong credit background will help you earn lower interest rates, more competitive terms and serve as a positive indicator outside of just finances. Credit checks and the weight that your credit score holds is an unavoidable truth in the current economy, so it is wise to work to continuously improve it.
When to consider taking out a personal loan
Personal loans are an important tool for financing large expenses like home renovations and debt consolidation. Even though you may see a temporary drop in your score, there are times when a personal loan may be the right choice to improve your credit.
- You don’t have many open accounts. If you’re just getting started, you may not have any credit history. A personal loan is a good way to start building your history since it will have a term of two to five years — and then stay on your credit report for up to seven once you finish paying it off.
- You only have revolving debts. Credit mix is a small portion of your score, but it still matters. If you only have credit cards, a personal loan can add diversity to your credit mix, showing lenders you are financially responsible enough to handle a variety of debt.
Any new debt can be risky to your finances. Be sure you can make your payments each month with a personal loan calculator, and know that a small decrease can easily be overcome by being responsible with your debt.