A personal loan offers fast access to a lump sum of money that you repay in fixed installments over a set period of months or years. Since personal loans are typically unsecured and don’t require collateral – much like credit cards – the lender determines your interest rate and eligibility based on your credit history.
Borrowing a personal loan can impact your credit score in a number of ways. But generally, taking out a personal loan and repaying it on time will have a more positive than negative effect on your credit score. Keep reading to learn how personal loans can help – and sometimes hurt – your credit score, so you can set realistic expectations when borrowing one.
How Personal Loans Affect Your Credit Score
Opening a new credit account, such as a personal loan, almost always requires a hard credit inquiry. You’ll likely notice a small drop in your credit score during the personal loan application process for this reason. Although a hard credit check is necessary for the lender to determine your ability to repay the loan, the negative impact on your credit score should be minimal.
In the long term, having a personal loan on your credit report may prove beneficial or harmful, depending on how you manage your finances after disbursement. That’s because borrowing a personal loan can affect your on-time payment history, credit mix, credit utilization and age of credit accounts – four of the five factors of your FICO credit score.
Having a good credit score under the FICO model will grant you better terms for borrowing money. Lenders look at your FICO score to determine your eligibility for all sorts of financial products, from mortgages to credit cards. The higher your credit score, the better your chances for getting approved for credit with a favorable interest rate.
With well-executed debt management strategies in the short term, you can improve your credit score in the long term – making it easier to achieve future financial goals like financing a car or buying a home. But tread carefully because mismanaging your personal loan debt can come with consequences for your credit. Here’s how it works:
When Personal Loans Can Help Your Credit
- Taking out a new type of debt will diversify your credit mix. Your mix of credit accounts – such as credit cards, installment loans or a mortgage – makes up 10% of your FICO credit score. Opening a personal loan, if you don’t already have one, can improve your credit mix, showing that you are capable of managing different types of debt.
- Installment loans can reduce your credit utilization. Your credit utilization, 30% of your credit score, is the amount of money you borrow compared with the available credit on your revolving credit lines, like credit card accounts. Since a personal loan is a type of installment loan and not revolving credit, it doesn’t add to your credit utilization. If you use a personal loan to pay off credit card debt, this can effectively lower your credit utilization to zero.
- Repaying the loan will improve your on-time payment history. Making timely payments on your loan each month can help you build a positive payment history. This is the most important factor under the FICO scoring model, accounting for 35% of your credit score. Keep an eye on your credit report to ensure your personal loan lender is reporting your on-time payments to the credit bureaus.
When Personal Loans Can Hurt Your Credit
- Applying for a personal loan triggers a hard credit inquiry. While it’s possible to prequalify for a personal loan with a soft credit check, formally applying for the loan will result in a hard inquiry. A single hard credit check will have a negative, yet minimal, impact on your credit score. However, applying for several credit accounts in a short amount of time can translate to greater risk, according to FICO.
- New accounts can lower your average age of credit. Having a diverse mix of mature credit accounts shows lenders that you have a long track record of responsibly managing debt. When you open a new credit account, your average age of credit will decrease. The length of your credit history makes up 15% of your FICO credit score, but the impact could be minimal if you have multiple older accounts already.
- Missed payments will result in a meaningful ding to your credit score. Since your on-time payment history is the largest component in your credit score, late payments or extended delinquencies can leave a hefty negative mark on your credit score – especially if you have good or excellent credit. If a payment is more than 30 days late, it could stay on your credit reports for up to seven years.
Alternatives to Personal Loans for Building Credit
If you’re not comfortable with your ability to repay a personal loan – or if you don’t meet the credit score requirements to qualify for one – you may still have other options for improving your credit history. Here are just a few steps you can take to build a better credit score.
Open a Secured Credit Card
Also known as a credit-builder credit card, a secured credit card gives those with bad credit a way to establish an on-time payment history. Here’s how it works: You put down a cash deposit, maybe $500, as collateral to reduce the risk to the lender. You can then use your secured credit card to borrow against that $500 deposit, paying off your balance in full each month. This allows you to reap the benefits of responsible credit usage if you can’t qualify for a traditional credit card account.
Become an Authorized User or Joint Cardholder
If you have a trusted friend or relative – think a spouse, sibling or parent – with very good credit, you may be able to hitch a ride on their creditworthy coattails, so to speak. By becoming an authorized user on someone else’s credit card account, you can effectively add their responsible financial habits to your credit report. When they make monthly payments or keep their credit utilization low, that will benefit your payment history and credit usage, respectively.
The same goes with opening a joint credit card, but this strategy comes with more strings attached. Becoming a joint cardholder means you’ll be equally responsible for repaying the debt if the other person goes into delinquency or default. With any joint credit account, it’s important to have an honest financial discussion to avoid turning a personal relationship sour.
Try a Pure and Simple Debt Repayment Method
Using a personal loan for debt consolidation may help improve your credit score and get you out of debt faster, but it’s not the only strategy. You might consider the debt avalanche method, in which you prioritize paying down the debt with the highest interest rate first. This can save you more money on interest payments in the long run.
Alternatively, the debt snowball method is when you pay off the accounts with the smallest balances first to generate momentum on your journey to becoming debt-free. Paying smaller accounts down to zero can also help lower your credit utilization faster, since it’s partly calculated based on the average of all your accounts. Watching your credit improve in baby steps can give you the motivation to complete your debt repayment journey.