Do Personal Loans Affect Your Credit Score

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Reviewed byAlvin Yam, CFP
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Updated: February 20, 2024

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Personal loans can impact your credit score, both positive and negative. For example, while it can help establish your payment history, missing payments may worsen your credit standing. Understanding these effects is important for making informed borrowing decisions. We'll explore how personal loans can help build your credit when managed well and the pitfalls to avoid that could harm your score. You can use this knowledge to manage personal loans wisely, ensuring they benefit your financial health.

What Is a Personal Loan?

A personal loan is a sum of money you borrow from a lender that you agree to pay back in set installments. It comes in two types: secured and unsecured. Secured loans require collateral, such as a car or home, which the lender can claim if you don’t repay. Unsecured loans don't require collateral, but they might come with higher interest rates due to the increased risk for the lender.

Personal loans are known for their fixed terms and interest rates. Your monthly payment remains consistent throughout the loan period, making budgeting easier. Once approved, you receive the entire borrowed amount as a lump sum allowing you to use it as needed unless your lender has specific restrictions regarding funds usage.

How Can a Personal Loan Help Your Credit?

Understanding how a personal loan can positively impact your credit score is essential for borrowers looking to enhance their financial health. You can use this knowledge to be more strategic about improving your creditworthiness.

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How Can a Personal Loan Hurt Your Credit Score?

Knowing the potential downsides of a personal loan is just as important as understanding its benefits. It equips borrowers and helps them avoid pitfalls that could harm their credit score. Let’s explore how a personal loan might negatively impact your credit, helping you stay vigilant and make smarter financial decisions.

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MONEYGEEK EXPERT TIP

Some lenders impose a prepayment penalty on personal loans. This is a fee that some charge if you pay off your personal loan before the agreed term, which adds to your total costs of the loan. A lender may charge by a specific percentage of the remaining balance or have a sliding scale that decreases over time. Before you borrow, review your loan agreement so that you’re clear whether a prepayment penalty exists, and if so, what is the specific amount of the penalty. — Alvin Yam, CFP®

Considerations Before Securing a Personal Loan

Before applying for a personal loan, evaluate how it could impact your credit score and overall financial health. Here are some factors to consider to ensure that a personal loan won't negatively affect your credit:

  • Your Financial Situation: Understand your current financial status, including your income, existing debts and monthly expenses. It helps you determine whether you can manage the additional loan payments comfortably without straining your finances.

  • The Terms: Carefully review the loan's interest rate, term length, monthly payment amount, and any fees. Ensure these terms are manageable and won't lead to financial strain.

  • Your Repayment Plan: Have a solid plan for how you'll make the loan payments. This might include setting up a budget or automatic payments to ensure timely repayment.

  • Multiple Applications: Applying for several loans in a short period can hurt your credit score due to multiple hard inquiries. Stick to applying for one loan that best fits your needs.

  • The Long-Term Impact: Consider how the loan fits into your long-term financial goals. Will it help you reduce overall debt, or could it potentially lead to more financial challenges?

MONEYGEEK EXPERT TIP

Credit insurance may be offered with personal loans. Credit insurance is meant to help borrowers with managing loan repayments in certain situations such as disability, unemployment, or death. Credit insurance can be expensive and you should carefully evaluate whether you really need it, especially if you already have disability or life insurance. — Alvin Yam, CFP®

Frequently Asked Questions About How a Personal Loan Affects Your Credit Score

Whether you're actively considering a personal loan or just seeking to expand your financial knowledge, these can provide valuable insights into the relationship between personal loans and credit scores.

Personal loans can be better for your credit score than credit card debt in certain situations. They typically have lower interest rates and can be used to consolidate high-interest credit card debts, thus reducing your credit utilization ratio and possibly leading to an improved credit score.

Paying off a personal loan earlier than needed can impact your credit score, but not always significantly. Early repayment can reduce your debt burden and improve your debt-to-income ratio. However, it may also shorten your credit history, particularly if the personal loan was your only installment account.

A personal loan stays on your credit report for up to ten years if it's managed well and paid as agreed. However, your credit report may reflect it for seven years if the account is closed due to default. This timeline begins from the date of when you first missed your due date, leading to the default.

Before taking out a personal loan, consider the interest rate, loan term, monthly payment amount and how it fits into your budget. Ensure that you can comfortably make the payments on time and use the loan for strategic financial purposes; this may include debt consolidation or necessary expenses, rather than discretionary spending.

Consolidating debt with a personal loan can positively impact your credit score. It simplifies your debt into one payment, potentially lowering your credit utilization ratio if you're paying off revolving debt like credit cards. However, it’s best to avoid accumulating additional debt on those credit cards after consolidation.

Defaulting on a personal loan can severely damage your credit score. A default remains on your credit report for seven years and indicates a significant lapse in your credit responsibility. It can make obtaining future credit difficult and often results in higher interest rates for any credit you qualify for.

To effectively manage a personal loan for credit score improvement, ensure timely payments, maintain a low credit utilization ratio and use the loan for responsible financial purposes like debt consolidation. Avoid using the loan to increase your overall debt and monitor your overall credit mix and total debt load.

The amount of a personal loan itself doesn’t directly affect your credit score. However, larger loans may result in higher monthly payments. In turn, these could impact your budget and ability to make timely payments. Your debt-to-income ratio also plays a role in your credit score and borrowing capacity.

Shopping for a personal loan can affect your credit score due to hard inquiries from lenders. To minimize this impact, try to limit your loan shopping to a short period, typically within 14 to 45 days. This way, credit bureaus often treat multiple inquiries for the same type of loan as a single inquiry, reducing the impact on your credit score.

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The content on this page is accurate as of the posting/last updated date; however, some of the rates mentioned may have changed. We recommend visiting the lender's website for the most up-to-date information available.

Editorial Disclosure: Opinions, reviews, analyses and recommendations are the author’s alone and have not been reviewed, endorsed or approved by any bank, lender or other entity. Learn more about our editorial policies and expert editorial team.