Will a Personal Loan Hurt Your Credit?

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Updated: May 23, 2024

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Personal loans are flexible financial tools that can be used for a variety of purposes, from consolidating debt to financing large purchases or covering unexpected expenses. These loans are typically unsecured, meaning they do not require collateral and are based on the borrower's creditworthiness.

Taking out a personal loan carries certain risks, especially concerning your credit score. The formal application for a personal loan requires a hard inquiry into your credit report, which temporarily lowers your score. The way you manage the loan — whether you make payments on time or miss them — significantly influences your credit health.

By understanding how a personal loan affects your credit, you can make more informed decisions about when and how to borrow, ensuring that you manage the loan responsibly to avoid negative hits to your credit score.

Key Takeaways

Applying for a personal loan requires a hard credit inquiry, which is likely to lower your credit score temporarily.

Before pursuing a personal loan, consider factors like your income, debt-to-income ratio and loan purpose to determine if it’s right for your needs.

Credit bureaus use factors such as payments, credit history, new credit, credit utilization and credit mix to calculate your credit score.

How Credit Scores Works

Your credit score is a numerical representation of your creditworthiness. Lenders typically use it to assess risk when lending. A good credit score shows that you are likely to repay debts on time and manage loans responsibly, which can lead to better interest rates and terms on loans.

A poor credit score indicates a higher risk of late payments or defaults, making lenders cautious. If you have a low score, you may face higher interest rates or even denial when applying for a personal loan.

To calculate your credit score, credit bureaus look at five factors, with each making up a certain percentage of your score. These include:

Percentage of Score
Factor
Description

35%

Payment History

This is the record of your consistency in paying bills on time. It forms the largest component of your credit score. Late payments, bankruptcies and defaults can significantly lower your score.

30%

Amounts Owed

Often referred to as the credit utilization ratio, this factor examines the total amount of credit you're using compared to your credit limits. Keeping your credit utilization ratio low, generally under 30%, is seen favorably.

15%

Length of Credit History

This takes into account the age of your oldest credit account, your newest credit account and the average age of all your accounts. A longer credit history can provide more data points and show reliability, which boosts your credit score.

10%

Credit Mix

This refers to the variety of credit types you manage, such as credit cards, personal loans, student loans and mortgages. A diverse credit mix can show your ability to handle multiple types of credit responsibly.

10%

New Credit

This factor looks at your number of new accounts, the length of time since you opened them and your recent requests for credit, known as credit inquiries. Opening several new credit accounts in a short period of time can be perceived as an increased risk, which might lower your credit score.

How Personal Loans Can Hurt Credit

Understanding the potential impact on your credit score before applying for a personal loan can help you mitigate the possible negative effects.

Hard Credit Inquiries

When you apply for a personal loan, lenders typically conduct a hard credit inquiry to assess your creditworthiness. This type of credit check temporarily lowers your credit score by a few points. Each hard inquiry signals to potential creditors that you're seeking new credit, which is interpreted as an increased financial risk if multiple inquiries are made within a short period.

Although you can't avoid a hard inquiry when applying for a personal loan, you can minimize its impact by prequalifying for loans first. Prequalification often involves a soft credit inquiry, which doesn't affect your credit score. This process allows you to explore various loan options and only pursue those where you're more likely to be approved, thus reducing the number of hard inquiries on your credit report.

Poor Loan Management

Payment history is the most influential factor in your credit score, accounting for 35% of the calculation. Any late payments on your personal loan are recorded in your credit history, potentially lowering your score and affecting your ability to secure future credit.

Before you finalize the loan application process, have a repayment strategy in place to ensure you can meet your payment obligations on time and maintain a healthy credit score. You can set up automatic payments, align payment dates with your paycheck and maintain a detailed budget to help keep you on track.

Higher Debt Load

When you apply for a personal loan, lenders assess your existing debt to determine your ability to handle new credit obligations. A high level of debt compared to your income — known as your debt-to-income (DTI) ratio — can make you appear riskier to lenders. Consequently, applicants with high debt loads may face higher interest rates or be denied.

However, you can strategically use a personal loan to consolidate existing debt. Combining multiple debts into a single loan with a potentially lower interest rate can simplify your payments and help lower your credit utilization ratio, a key factor in credit scoring. This will likely boost your credit score.

Factors to Consider Before Getting a Personal Loan

A personal loan is a significant commitment that can affect your financial health. Before applying for one, it's best to carefully consider its suitability for your situation — and your ability to repay.

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    Credit Score

    Your credit score directly influences the terms you'll receive from lenders. A higher credit score typically leads to more favorable terms, such as lower interest rates and better loan conditions, reflecting your proven track record of managing debt responsibly.

    A lower credit score usually results in higher interest rates or even denial of your loan application, as lenders perceive a greater risk in extending credit to you. Before applying, review your credit score to gauge your eligibility and potentially improve it to secure the best possible loan terms.

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    Income and Debt-to-Income Ratio

    Lenders use your income to verify your ability to repay the loan, while your DTI ratio, which is the percentage of your monthly income that goes toward paying debts, helps them assess your financial health.

    A low DTI ratio suggests that you have a good balance between your earnings and your debt obligations, enhancing your attractiveness as a borrower. On the other hand, a high DTI ratio can be a red flag for lenders, potentially leading to less favorable loan terms or denial of the application.

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    Loan Amount

    As a rule of thumb, only borrow what you need to avoid excessive debt and manage repayment comfortably. Requesting a loan amount that aligns with your specific financial requirements and repayment capacity will not only simplify managing your finances but also make it easier to secure loan approval.

    Lenders assess loan applications based on the requested amount relative to the borrower's income and creditworthiness, so choosing an amount you can reliably repay without financial strain is practical.

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    Loan Purpose

    The reason for your loan influences the type of loan you might seek and the terms you might accept. For instance, loans for debt consolidation often have different terms than loans for home renovations or medical expenses.

    Understanding your loan purpose helps you clarify the amount needed and assess the feasibility of the repayment plan. It also allows lenders to evaluate how the loan fits into your financial situation, which can affect the approval process and the terms offered.

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    Monthly Payments

    Before applying for a personal loan, determine whether the monthly payments fit comfortably within your budget without straining your finances. This will help you understand your commitment and ensure you can maintain it over the term of the loan.

    It also prevents financial stress and potential damage to your credit score due to missed payments. Consider using a personal loan calculator to estimate monthly payments based on different interest rates and repayment periods to find a balance that works with your monthly income and expenses.

IMPACT OF EARLY CLOSURE OF A PERSONAL LOAN ACCOUNT

"Early closure of a personal loan account can have positive and negative impacts.

  • Positive Impact: It improves your credit utilization ratio by reducing your outstanding debt, which can boost your credit score.
  • Negative Impact: It shortens your credit history, a key factor in your credit score. A longer history usually results in a higher score.

Before deciding to close a personal loan account early, consider these areas:

  • Credit Score: Keeping the account open could be beneficial if you have a high score and have a goal, such as qualifying for a mortgage.
  • Debt Levels: If you have other high-interest debts, it might be better to pay those off first.
  • Future Credit Needs: If you need a personal loan down the road, keeping the current account open helps you establish a positive payment history.

Instead of fully closing the account, consider making a lump sum payment to reduce the balance and keep the account open. This can improve your credit utilization ratio while also keeping your credit history."

— Alvin Yam, CFP

FAQ About Credit Scores and Personal Loans

We addressed some frequently asked questions about credit scores and personal loans to provide some valuable insight into maintaining your financial health.

Can you get a personal loan with a bad credit score?
How can you improve your credit score to get better loan terms?
What is the minimum credit score required for a personal loan?
How much can you borrow with a personal loan?
Does paying off a personal loan early affect your credit score?
What should you do if you can't make a payment on your personal loan?

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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.

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