Will a Personal Loan Hurt Your Credit?
Updated: September 26, 2023
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Taking out a personal loan can be beneficial. It's versatile, allowing you to use it for several things. These may include paying medical bills, making significant purchases or even consolidating existing debt. Managing it well can work to your advantage — making consistent and timely payments can improve your credit standing.
However, taking out a personal loan also comes with some risks — especially to your credit. Most lenders conduct hard inquiries as part of the application process, which knocks off several points from your credit score.
Knowing how a personal loan affects your credit is crucial if you want to remain financially healthy. After all, your credit score can affect many aspects of your finances, including your interest rates and insurance premiums.
How Your Credit Score Works
Have you ever wondered why lenders keep charging you high-interest rates? Or why do you have a more expensive insurance premium? The answer may lie with your credit score.
In a nutshell, your credit score is a numerical representation of your creditworthiness. A good credit standing sends the message that you can manage debt well. From a lender's point of view, it makes you less of a risk if you're applying for a personal loan. As a result, they may offer more competitive rates.
In contrast, you're more likely to get higher interest rates if your credit score is fair or poor — typically a FICO score of 669 and lower. If you have a personal loan and your lender charges more interest, it may make repayments more challenging.
It's different from a credit history, which looks at your loans and credit card balances and repayment activity. This information, along with your personal details, collection items and public records, is put into a single document — your credit report.
Credit bureaus are organizations that calculate your credit score. They look at multiple factors, such as payment history, length of credit history and credit mix. The three most prominent credit bureaus are TransUnion, Equifax and Experian.
What Makes Up Your Credit Score?
To understand how your credit score works, you need to know the computation behind it. Credit bureaus look at five factors to determine your credit score. These factors each make up a certain percentage of your score. Knowing these can help you develop strategies to boost your credit standing. You'll also have an idea of what activities to avoid.
Credit Score Contributing Factors
How Can a Personal Loan Hurt Your Credit?
It’s best to examine several factors to understand how personal loans affect your credit. Although it may help you establish credit, there are also many ways that it could hurt your credit score. However, there are steps you can take to minimize its impact even if you can’t avoid it altogether.
Lenders usually conduct a hard credit inquiry when you apply for a personal loan. Although it only lowers your credit score by less than five points, the effect can become substantial if you pursue multiple applications within a short period.
Because it’s part of most lenders’ processes, there’s no way to avoid it. However, see if your lender has a pre-qualification process. Pre-qualifying won’t affect your credit score and gives you an idea of what loan amount and interest rates you can get.
This way, you can pursue only those personal loan applications where you’re more likely to be approved.
Once your loan application is approved, your primary objective becomes ensuring you repay it. However, it’s best to have a repayment strategy before completing the loan application process.
Remember, missed or delayed payments on your personal loan can hurt your credit score. Those count against your payment history, which is 35% of the calculation. One way of determining whether you can afford your monthly due is by calculating your loan payments in advance.
This way, if it comes out too expensive, you can make some adjustments. These may involve decreasing your loan amount or getting a co-signer to get better rates.
Ensure that you don’t borrow more than what you need. A higher loan amount may give you more cash on hand when the money is released, but it also means your monthly payments will be more expensive.
Debt load refers to the total amount of money you owe across different accounts. These include the balances on your credit cards, mortgages and other installment loans.
When you apply for a new personal loan, one of the areas that lenders review is how much existing debt you have. Borrowers with high debt loads may get higher interest rates because lenders consider them riskier (the amount of debt you already have may make repaying a new one challenging).
You may consider using your personal loan to consolidate existing debt. It can help you lower your debt load and decrease your credit utilization, which boosts your credit score.
Factors to Consider Before Getting a Personal Loan
Given that personal loans can affect your credit score, getting one is something requiring considerable thought. It's still a commitment, regardless of the loan amount. Here are the essential factors to explore before applying.
Your credit standing can affect your personal loan experience considerably. A high credit score tends to get you more competitive rates since lenders view you as creditworthy.
If your credit score is less than ideal, be prepared to pay higher interest. In turn, it makes your monthly payments more expensive. It may mean that repaying your loan becomes more challenging — and remember, missed payments may result in late fees and a lower credit score.
Whether or not you can repay your loan should be your primary concern. A regular income makes repaying your loan more achievable.
However, besides the amount you earn, it's also crucial to understand how much of your income already goes toward repaying existing debts. A lower figure means you have the financial flexibility to take on more debt. However, a higher debt-to-income (DTI) ratio means you have less to spare, so a personal loan may not be the best choice presently.
It's best to know how much money you need. A higher loan amount may prompt lenders to deny your application if you're borrowing a large amount but can't prove you have the means to repay it.
However, you must also ensure that you still will receive the amount you need after the initial fees lenders charge. For example, some origination fees go up to 8%. That can eat up a significant chunk of your proceeds, leaving you in a financial bind.
What makes personal loans attractive to borrowers is their flexibility. While most application processes will ask you to state why you're taking out a loan, most lenders don't impose restrictions on how you can use your proceeds.
However, there are cases when restrictions apply. For example, Upgrade prohibits borrowers from using their proceeds to pay for secondary education or activities considered gambling.
Knowing how much you need to set aside each month to repay your personal loan is crucial. Remember, you're committing to making all the necessary repayments for the entire duration of your loan, whether for the next two, four or five years.
It's best to see how your new monthly payments fit your existing household budget. Remember, missing payments subject you to fees and may pull down your credit score.
Frequently Asked Questions About Credit Scores
Understanding how a personal loan affects your credit is essential to maintaining your financial health. MoneyGeek provides additional information through these commonly asked questions. These may cover areas about this topic not answered by the sections above.
Credit scores can range from 300 to 850, depending on several factors. As of April 2021, the average FICO score in the U.S. is 716.
23.1% of the population has scores between 750 and 799, while 23.3% have scores between 800 and 850. Combined, that's around 46% of the population.
Whether using FICO or VantageScore to determine your creditworthiness, the lowest possible score is 300.
The following activities can help increase your credit score:
- Make timely payments on your existing loans.
- Keep your credit utilization low.
- Avoid maxing out your credit cards.
- Have a healthy mix of credit accounts.
- Maintain a lengthy credit history.
Remember, you must have credit to build credit, so the belief that having no debt can result in an excellent credit score isn't necessarily true. You won't have a high credit score if you don't have any credit activities.
However, it's possible to have debt and maintain good credit standing. Your credit score won't go down as long as you make on-time payments of at least the minimum agreed-upon amount and keep your credit utilization low.
Admittedly, paying your loan early has its advantages. For example, it decreases your debt-to-income ratio, making you more financially fluid. However, because of the different factors affecting your credit score calculation, completing your repayments ahead of time may cause your score to dip.
For example, if you use multiple credit cards and only have one personal loan, you won't have a good credit mix once you pay the latter. It also reduces your overall credit line, so if you max out your cards, your credit utilization skyrockets, hurting your credit standing further.
First, there are different scoring models. Even if you narrow it down to the most popular ones, there are still two possibilities — FICO and VantageScore. If you and your bank use different models, you'll come up with differing scores.
Second, your scores depend on the information credit bureaus receive from merchants and lenders. Unfortunately, not all provide data to all bureaus, so the score depends on where they requested it.
sources
- MyFICO. "Credit Checks: What are Credit Inquiries and How Do They Affect Your FICO Score?." Accessed September 17, 2022.
- FICO. "Average U.S. FICO® Score at 716, Indicating Improvement in Consumer Credit Behaviors Despite Pandemic." Accessed September 17, 2022.
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.
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