How does a personal loan affect your credit score?

A personal loan can improve your credit score over time when you manage it properly. However, the initial inquiry — and any missed or late payments — may cause your credit score to drop temporarily. If you’re uncertain as to how a personal loan will impact your credit, look at your current ability to handle another monthly payment. Your score will drop significantly if you miss payments or are late making them.

That said, a personal loan can improve your credit score over time and result in more competitive interest rates in the future — provided you understand the potential downsides before you borrow.

How taking out a personal loan affects your credit

When you apply for a personal loan, the hard inquiry may result in a small negative impact on your score for a year. This is a temporary drop, and may only be about five points, though it can vary.

When managed carefully, a personal loan can be beneficial, even with a drop from the initial credit inquiry. This is because it will contribute to your overall credit profile. Personal loans increase your payment history, diversify your credit mix and can decrease your credit limit.

How a personal loan can help your credit

A personal loan can benefit you by adding an installment loan 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 payment history accounts for the largest portion — 35 percent — of your FICO score. Consistent, on-time payments on your personal loan will help increase your score over time. It may take a few months for the benefits to add up. And if the inquiry caused your score to drop, it may take at least a year to offset the negative impact of a hard inquiry from when you apply with a lender.

Credit mix

Your credit score also benefits from having a variety of accounts open. 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. The more types of credit you have, the more you prove you are able to handle debt responsibly.

Credit utilization ratio

Using a personal loan to consolidate credit cards 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 credit limit you are using.

For example, if you have two credit cards with a total credit limit of $10,000, and you are carrying a balance of $6,000, your credit utilization ratio would be 60 percent. Consolidating $5,000 of that debt with a personal loan would reduce your credit utilization to 10 percent. Provided you keep your credit card spending low, you will see a decrease in your credit utilization ratio — and an increase in your credit score.

How a personal loan can hurt your 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 credit score, late or missed payments can lower it. Those late payments can stay on your credit report for up to seven years.

Unfortunately, there is little to be done when you miss payments. They’ll stick around, and you will need to focus on paying your loan regularly to offset any late or missing payments you made on your personal loan. However, recent history is weighted more heavily than history that is further back.

Amount owed

When you take out a personal loan, the amount owed on your credit also increases. This may cause you to see a slight dip in your score. Amount owed is made up of five different factors, and how much you have left on installment loans is part of that. It also considers how much is owed in total across different types of credit accounts.

Hard credit inquiry

Lenders will run a hard credit pull whenever you apply for a loan, which can lower your credit score. However, your score should go up again in the following months after you start making payments.

In addition, too many credit applications at once can be a bad sign to potential lenders. Most lenders offer a preapproval process so you can avoid a hard inquiry until you are ready to borrow — but that’s not always the case. Check how the lender will evaluate your application to avoid unnecessary hits to your score.

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.

A personal loan is not necessary to build a healthy credit score, but there are a few ways it can positively affect your credit.

• You don’t have many open accounts: If you’re just starting out, you may have no credit history. A well-managed personal loan is a good way to start building your history since terms typically last 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.
• You want to save money: A personal loan can be used for debt consolidation, among other ways to save money. In some cases, a personal loan may help you lower your average interest rate across accounts and help you avoid the fees charged by credit cards.

Bottom line

Any new debt can be risky to your finances, so consider personal loan alternatives before applying. Be sure you can make your payments each month with a personal loan calculator, and know that a small decrease in your credit score can easily be overcome by being responsible with your payments.