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.
Do Personal Loans Affect Your Credit Score
Securing a personal loan can affect your credit score in different ways. An application involves a hard credit check, which lowers it, but using a personal to consolidate debt may help improve your overall credit standing.
Zachary Romeo, CBCA
Head of Loans and Banking at MoneyGeek
Zachary Romeo is a certified Commercial Banking and Credit Analyst (CBCA), and the Head of Loans and Banking at MoneyGeek. Previously, he led production teams for some of the largest online informational resources in higher education, with over 13 years of experience in editorial production. Romeo has a bachelor's degree in biological engineering from Cornell University. He geeks out on minimizing personal debt and helping others do the same through people-first content.
Alvin Yam, CFP
Founder, Paraiba Wealth Management
Alvin Yam is a certified financial planner (CFP) with over 15 years of experience working with individuals and corporations. Before founding Paraiba Wealth Management, he was a director at HSBC and a financial consultant at Charles Schwab. Yam is MoneyGeek's expert consultant on wealth management and personal banking. Yam earned his bachelor's degree in political science from the University of California, San Diego, and his Master of Business Administration from Loyola Marymount University.
Rae Osborn
Content Editor
Dr. Rae Osborn is a MoneyGeek content editor with over seven years of editing experience and over 20 years of experience in publishing and writing science content. She also works as a science researcher, writer and editor and a professional reviewer for Science Reviews and Advances in Entomology.
Zachary Romeo, CBCA
Head of Loans and Banking at MoneyGeek
Zachary Romeo is a certified Commercial Banking and Credit Analyst (CBCA), and the Head of Loans and Banking at MoneyGeek. Previously, he led production teams for some of the largest online informational resources in higher education, with over 13 years of experience in editorial production. Romeo has a bachelor's degree in biological engineering from Cornell University. He geeks out on minimizing personal debt and helping others do the same through people-first content.
Alvin Yam, CFP
Founder, Paraiba Wealth Management
Alvin Yam is a certified financial planner (CFP) with over 15 years of experience working with individuals and corporations. Before founding Paraiba Wealth Management, he was a director at HSBC and a financial consultant at Charles Schwab. Yam is MoneyGeek's expert consultant on wealth management and personal banking. Yam earned his bachelor's degree in political science from the University of California, San Diego, and his Master of Business Administration from Loyola Marymount University.
Rae Osborn
Content Editor
Dr. Rae Osborn is a MoneyGeek content editor with over seven years of editing experience and over 20 years of experience in publishing and writing science content. She also works as a science researcher, writer and editor and a professional reviewer for Science Reviews and Advances in Entomology.
Updated: September 17, 2024
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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.
It Helps Establish Payment History
When you make loan payments on time, every time, it tells credit bureaus you're a reliable borrower. Consistency is key, as payment history is a major component of your credit score. By ensuring each payment is made by the due date, you're building a track record of financial reliability.
And it doesn't only apply to large payments — even smaller, regular payments contribute positively. Over time, it can lead to an improved credit score, making it easier for you to qualify for future credit or loans under more favorable terms.
It Lowers Credit Used
Using a personal loan to pay off credit card debt can be a smart move for your credit score. It lowers your credit utilization ratio, which is the percentage of your available credit that you're using.
Credit bureaus favor a lower ratio, as it suggests you're not overly reliant on credit. For instance, if you have $5,000 in credit card debt and a total credit limit of $10,000, your utilization ratio is 50%. Taking a personal loan to clear this credit card debt effectively reduces your utilization ratio to zero on those cards. That can positively affect your credit score, reflecting responsible credit management. Be careful not to accumulate more credit card debt after clearing it with a personal loan, as it could negate the benefits.
It Diversifies Your Credit Mix
Adding a personal loan to your credit portfolio enhances your credit mix. In turn, it positively influences your credit score. Credit bureaus look favorably on a diverse mix of credit types, such as credit cards, personal loans, auto loans and mortgages. It demonstrates your ability to handle various forms of credit responsibly.
If you only have credit cards in your credit history, adding a personal loan shows a broader range of credit management skills. It’s like showing you're not just good at one type of financial responsibility, but several. Managing the mix well, especially by making timely payments on your personal loan, can gradually boost your credit score, making you more appealing to future lenders.
It Can Simplify Debt Management
Debt consolidation through a personal loan can streamline your financial management, positively affecting your credit score. It involves combining multiple debts, like credit card balances, car loans or other personal loans, into one single loan. The benefit lies in simplification: instead of keeping track of several payments with different interest rates and due dates, you have just one monthly payment to manage.
Suppose you're currently managing separate payments for a car loan, two credit cards and a retail account. In that case, consolidating these into one personal loan reduces your monthly juggling to a single payment. You’ll be less likely to miss a payment, which is fundamental to maintaining a good credit score.
It Lengthens Credit History
When you take out a personal loan and maintain it over its full term, it adds to the length of your credit history, which is a key factor in calculating your credit score. A longer credit history provides more data points, showing how you've managed credit over time.
For instance, if you take a personal loan with a five-year term and make consistent payments, it demonstrates a sustained commitment to managing credit. Credit bureaus view this favorably because it indicates a reliable borrowing pattern. An extended period of consistent credit management can gradually improve your credit score, especially if it's coupled with other positive financial behaviors like keeping low balances on credit cards and paying other loans on time.
It Can Be a “Credit Builder” Personal Loan
Credit builder loans are a unique type of personal loan designed specifically to help build or improve your credit score. With these loans, your lender holds the funds in a bank account while you make monthly payments towards it. These payments are reported to the credit bureaus, contributing positively to your credit history. Once the loan is fully paid off, you gain access to the funds.
Credit builder loans are an effective tool for establishing a pattern of consistent, reliable credit behavior for individuals working towards building a solid credit foundation. It’s ideal for those who are new to credit or looking to repair their credit score.
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.
Missed Payments
One of the quickest ways a personal loan can hurt your credit score is through missed or late payments. Your payment history is a major component of your credit score calculation, and even a single missed payment can cause a significant drop. A missed monthly payment gets reported to the credit bureaus, which can stay on your credit history for up to seven years. Regularly missing payments tell lenders that you're a high-risk borrower, which not only affects your current score but also your ability to secure favorable credit terms in the future. Staying on top of your loan repayments is essential to maintain a healthy credit score and avoid the long-term consequences of negative reporting.
Debt-to-Income Ratio Increases
Securing a personal loan adds to your total debt, impacting your debt-to-income ratio (DTI). A high figure can signal to credit bureaus and lenders that you might be overextended financially. For instance, if your income is $3,000 per month and your debts, including your new personal loan, amount to $1,500 per month, your DTI is 50%.
A high DTI not only lowers your credit score but can also make it more challenging to obtain additional credit. It's important to consider your existing debts and income before taking on a personal loan to ensure it doesn't tip your DTI balance unfavorably.
Hard Credit Inquiries
When you apply for a personal loan, lenders conduct a hard inquiry to review your credit report. It temporarily lowers your credit score by around five points. Imagine if you apply for several personal loans within a short period, each application triggering a separate hard inquiry. While one inquiry may have a minor impact, multiple inquiries in a short time can be more detrimental. It may also give the impression that you're in financial distress or taking on more credit than you can handle, thereby reducing your credit score. It's wise to limit the number of loan applications you submit and only apply for a personal loan when it's necessary to minimize the impact on your credit score.
Decrease in Average Age of Your Credit Accounts
The length of your credit history accounts for a portion of your credit score calculation, with a longer one typically being more beneficial. Having several long-standing credit accounts and then taking out a new personal loan lowers the average age. The effect can be greater if you don't have many older credit accounts.
A younger average age can signal less experience in managing credit, potentially leading to a drop in your credit score. Balancing new credit with established accounts is key to maintaining a healthy credit score, particularly if you're still building or rebuilding your credit profile.
Default
Defaulting on a personal loan can severely impact your credit score. It occurs when you fail to make several payments as agreed upon in the loan terms. Once your loan defaults, it’s reported to the credit bureaus and becomes a negative entry on your credit report.
A default can significantly lower your credit score and remain on your credit report for up to seven years, making it difficult to obtain new credit, secure favorable interest rates or even pass certain employment background checks. You should avoid default at all costs, and if you're struggling with payments, it's better to communicate with your lender about potential solutions or adjustments to your payment plan before the situation escalates.
Early Payoff
Paying off a personal loan early can save you money on interest, but it might not always help your credit score. It can shorten your active credit history, particularly if it's your only installment account. Regular, on-time payments positively impact your score, and closing the loan ends this stream of positive reporting.
While it's financially sound to clear debt early, it's also good to consider the effect on your credit history. For those building credit, the consistent payment history of a loan is valuable. If you choose to pay off a loan early, ensure you have other active credit lines to continue building a positive credit history. Balancing early repayment with a diverse credit portfolio is key.
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?
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.
About Zachary Romeo, CBCA
Zachary Romeo is a certified Commercial Banking and Credit Analyst (CBCA), and the Head of Loans and Banking at MoneyGeek. Previously, he led production teams for some of the largest online informational resources in higher education, with over 13 years of experience in editorial production.
Romeo has a bachelor's degree in biological engineering from Cornell University. He geeks out on minimizing personal debt and helping others do the same through people-first content.
sources
- MyFico. "Credit Checks: What are Credit Inquiries and How Do They Affect Your FICO® Score?." Accessed September 17, 2024.
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