When you take out a personal loan, you will likely lower your credit score in the short-term. This is because you are lowering the average age of your open accounts and adding to the total amount you owe. The application itself also creates a temporary drop in your score.

But this short-term risk often doesn’t outweigh the benefits of taking out a personal loan for financial milestones like debt consolidation, home remodeling or emergency expenses.

What makes up your credit score?

A FICO credit score consists of five main elements: payment history, amounts owed, length of credit history, new credit and credit mix. FICO uses these factors to calculate your score.

FICO isn’t the only credit score that is used by lenders. VantageScore is another one that’s used, and it’s made up of six factors: payment history, credit age and mix, utilization, new credit, balance and available credit.

How an open personal loan affects your credit

Debt from any sort of loan can create negative implications for your financial health if they’re not properly managed and an open personal loan is no different. But a personal loan that is paid on time and managed can also be beneficial for your credit.

Positive effects

Taking out a personal loan can improve your credit in a number of ways.

  • Timely payments. Your ability to pay on time makes up for 35 percent of your FICO and 41 percent of your VantageScore — the largest portion for both. So, presuming you consistently pay on time, your credit score could increase.
  • 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 leave you with a variety beyond revolving accounts.

Negative effects

Before taking out a personal loan, consider how it can negatively impact your credit score.

  • Missed payments. Paying your personal loan, on time and in full is of utmost importance when it comes to borrowing. It makes up the majority of your FICO credit score and VantageScore.
  • Amount owed. As the amount owed on your personal loan grows — which makes up for 30 percent of your FICO credit score — you may see a slight dip in your score. FICO considers amounts in several lights, including the overall amount owed. It also considers revolving accounts, like credit cards, versus installment accounts, like personal loans.
  • Hard inquiry. Any time you apply for a loan, lenders will run a hard credit pull. This will temporarily drop your score. This resolves quickly if you don’t have too many inquiries close together.

How credit score affects your overall financial health

Your credit score serves as an indicator of your financial reputation. The number places you in a category that tells lenders your potential risk.

But this number is important even if you are not shopping for a loan. In some states, insurers, employers and landlords can use your credit as a touchstone for reliability. A score in the 300 to 579 range, considered poor by FICO, might keep you from being approved for your dream home or extending your line of credit to purchase a big-ticket item.

The three-digit credit score factors into your personal loan eligibility — but also credit cards, mortgages, car loans and noncredit products. 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.

Average personal loan interest rates by credit score

Consider the breakdown of average rates based on credit. As displayed, the lower your credit score is the higher your interest rate will be. This is true when it comes to APRs across the financial board.

Credit score Average loan interest rate
720-850 10.73%-12.5%
690-719 13.5%-15.5%
630-689 17.8%-19.9%
300-629 28.5%-32%

How to improve your credit score

While taking out a personal loan may cause a slight decrease in your credit score, there are still some choices you can make to ensure that your credit will head on an upward trajectory.

Stay on top of payments

On-time payments make up a huge part of your overall credit score, regardless of the scoring model used. This means paying your bills on time is one of the most important factors when it comes to improving your credit score. Consider signing up for automatic payments or setting reminders on your phone so you never miss a payment.

Consistently check your credit reports

Every 12 months it is wise to use AnnualCreditReport.com, as recommended by the U.S. government, to check your credit report with each of the three major bureaus: Equifax, TransUnion and Experian. By checking up on your score you can look out for any errors or major issues.

Lower your credit utilization rate

Your credit utilization rate is the amount of credit you have used in comparison to the limits available. The Consumer Financial Protection Bureau recommends that you keep this number below 30 percent.

To calculate your credit utilization rate, divide your combined credit card balances by your combined credit limits. The lower the number is, the better. Paying off your credit card balances in full every month will keep your credit utilization rate low.

The bottom line

While taking out a loan of any sort can carry financial risk, do not let that fear hold you back from taking out a personal loan for your needs. To ensure you can make your payments each month and not owe more than you can afford, use a personal loan calculator to figure the number ahead of time. That way your credit score can remain unscathed — even while owing money on a personal loan.