How Personal Loans Affect Your Credit Score

Arjun Ruparelia

Arjun Ruparelia

Published on: 27 December, 2021

Updated: 06 March, 2022

Credit Score

If you are in the United States, obtaining a personal loan affects your credit score in several ways, both positively and negatively. How you are impacted primarily depends on two factors. 

  1. The scoring models used by FICO and credit bureaus (Experian, Equifax, TransUnion) to calculate your credit score.
  2. The way you use your personal loan funds.

Let’s dive into each of these.

Personal loans are a great way to get some quick cash, and can even be used as a debt consolidation tool. Used the right way, personal loans can improve your credit score. If you make timely payments and build a reliable payment history, you’ll likely improve your credit report and thus increase your credit score over time.

One of the best ways to build a great credit score is to pay balances on time and consistently. In fact, Experian tells us it’s better to make smaller payments more often than large payments less often. Therefore, if you’re paying off a personal loan in a consistent and timely manner, it’s certain to improve your credit score over time.

However, if you are not careful, obtaining a personal loan can hurt your credit score. For instance, if you already have a mountain of debt, and you apply for a personal loan, you’ll increase your amounts owed (i.e., your total debt), which could hurt your credit score. Plus, with more debt, lenders will perceive your future loan applications as high risk and charge a higher interest rate, or reject your loan application altogether.

All things considered if you're finding it tough to get a loan from a bank or credit union, getting a personal loan from your loved ones can be a smart move. Although you may not be able to boost your credit score if the loan is coming from your best friend or brother, personal loans from people you trust are often a lot more flexible and can help you in a time crunch. Regardless of their effect on your credit score, you have many great options for securing your financial future by obtaining a personal loan.

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Can A Personal Loan Hurt Your Credit Score?

Getting a personal loan when you're already under a lot of financial stress can often spell bad news for your credit score. For instance, say there’s an attractive discount available on a car you’ve been wanting to buy. However, the discounted price is outside of your budget. You consider getting a car loan to make the most of the discount, but since you don’t qualify for one, you apply for a personal loan. You buy the car, but when it's time to make payments, you feel stressed. You miss payments and hurt your credit score.

This is why it’s important to know how personal loans can hurt your credit score. Assuming your lender reports your personal loan to a credit rating agency (not all lenders do), several things during the application process and after you’ve secured the loan can put a dent in your credit report.

💡 Did you know that simply applying for a personal loan can also affect your credit score?

Hard Inquiries

A hard inquiry occurs when you apply for new credit and a lender subsequently pulls your credit report at the time of assessing your creditworthiness via a loan application. In order to offer you the best personal loans, lenders look at your credit history to gauge your creditworthiness. Based on their assessment and your length of credit history, they’ll decide whether to lend you money and on what terms.

Hard inquiries typically stay on your credit report for up to two years, and during that time they will appear as a negative mark on your credit history. The extent of a hard inquiry’s impact depends on the applicant's financial position. Typically, a hard inquiry will result in a drop of five or fewer points. But if you have a strong credit history, the drop in scores may be smaller.

Too many hard inquiries in a short period of time can lead to poor scores when undergoing a credit check, this reality may yield a decrease in the loan amount you are looking for, and ultimately will convey to your lenders that you may be facing insurmountable financial challenges in your personal finance journey. 

This may seem like a sticky situation if you hope to go apply with several lenders looking for the best rate. But the good thing is, you can check your credit score before you apply for a personal loan by undergoing a soft inquiry and no damage will be done to your score unlike the consequences of a hard inquiry.

Hammer

Missing Payments

Your payment history is the most important factor impacting your credit score. Positive payment history and even negative payment history account for 35% of your FICO score. So when bureaus like Transunion, Experian, and Equifax calculate your credit score, they are focusing mainly on long-term payment history, rarely short-term.

💡 Consistently making all the payments for an entire loan term is key to building a good credit score. 

Ideally, you should make your personal loan payments as they become due. While missing payments isn’t good, a one-off instance isn’t the end of the world. Your lender will typically charge you a late fee for the missed payment, and potentially a higher APR (interest on your loan), but a late or missed payment typically won't end up on your credit report if you pay off any amount due within 30 days after you missed a payment.

If however, you miss payments, usually monthly payments, beyond the 30-day mark, you could incur severe consequences. If a late payment makes it to your credit report, it may stay there for up to seven years! So bottom line - don't miss payments when paying off a personal loan.

Can A Personal Loan Improve Your Credit Score?

Yes, a personal loan can help you improve your credit score. Whether or not a personal loan does improve your credit score ultimately boils down to you being a smart borrower who can manage your finances well.

Personal finance in regards to these types of loans is a tricky topic that many people struggle with, but luckily there are some tried and true tips you can implement to increase your chances of boosting your credit score. If you're hoping to use your next personal loan as a tool to improve bad credit, you should know about the following factors that can positively influence your credit score.

Make Timely Payments

Quite intuitively, you can use your personal loan to improve your credit score by making timely payments. Making timely personal loan payments helps you build credit and demonstrates to lenders that you are financially responsible enough to manage additional lines of credit. Research suggests that people who have a strong track record of making on-time payments tend to be more likely to pay their debts in full

As you can imagine, getting paid back is the most important thing for lenders; this is why timely payments carry a significant amount of weight on your FICO score. So no matter how large your student loan payments are, make sure you pay them off every month 😉.

Diversify Your Credit Mix

If you didn’t know already, credit mix, i.e., the types of active credit accounts you have, is an important factor that influences your credit score. Your credit mix can include mortgages, credit cards, and yes, even personal loans. If we dig a little deeper, we should also note that credit can be of two types—revolving credit and installment credit. 

Revolving credit is a borrowing agreement that allows you to take money out or put it back into the account as often as you want, provided you don't exceed your credit limit. Ring a bell? This is how your credit cards and related lines of credit work. 

Installment credit is a borrowing agreement that comes with a repayment schedule that tells you exactly when you need to make payments over a predefined loan term. The disbursements and withdrawals for an installment credit account tend to be less flexible than revolving credit accounts and may even include origination fees. Examples of installment loans include mortgages, car loans, and personal loans…you get the idea.

So, why does this matter for your credit score?

Well, diversifying your credit mix can help improve your credit score, especially if you only have revolving credit accounts like credit cards. The reason? Credit scoring models look favorably upon borrowers who can manage various types of credit accounts - so mix it up!

Building Steps

The Smart Way to Use Personal Loans

You can use a personal loan for pretty much anything, from rolling over student loans to consolidating high-interest debt in an effort to reduce your credit card balances, personal loans are a powerful tool you should use in your personal finance arsenal.  Not only do personal loans provide you with financial flexibility, but they also can positively impact your credit score if used responsibly.  

Whether you go to a bank, create a personal loan with a friend or family member, or even seek financial opportunities elsewhere, make sure you consider all of the ways you may impact your credit score. Just following a few of our best practices will have you well on your way to that 800 credit score you’ve been dreaming of!

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