If you’re interested in taking out a personal loan, you may be wondering if it will affect your credit score. Does a personal loan hurt your credit or help it? The short answer is that a personal loan will affect your credit score positively and negatively. The long answer is much more complicated than you might think.
So, how do personal loans affect your credit score? Let’s take a closer look at how credit scores work to find out.
- What is a personal loan?
- How your credit score works
- How personal loans can hurt your credit
- How personal loans help build your credit
- What to consider before getting a personal loan
- FAQs
- Final thoughts
What is a personal loan?
A personal loan is money you borrow in a lump sum and slowly pay back over time by making monthly or biweekly payments. Personal loans can be used to pay for various expenses, including:
- Vehicle repairs
- Home improvements
- Debt consolidation
- Weddings
- Parties
Lenders, banks, and credit unions offer personal loans.
Personal loans vs. credit cards
Personal loans are different from using a credit card. With a personal loan, you receive a lump sum of money up front and make regular payments on the loan. These payments are all of the same size.
With a credit card, you borrow different sums of money each time you use the card. Your payment size changes each month based on how much you have borrowed during that specific period of time.
Usually, personal loans have lower interest charges than credit cards. In many cases, people can pay off a personal loan faster than they can pay off credit card debt.
How your credit score works
Your credit score is a number that lenders use to predict your future credit behavior, including your likelihood to pay back a loan on time. Your credit score is calculated using information from your credit reports.
Credit reports track your credit history over approximately the last seven years. They’re compiled by three main credit bureaus: Experian, TransUnion, and Equifax.
It’s important to understand the factors that go into calculating your credit score. Let’s look at what information is often included in credit reports and how that information is weighted to determine your score.
Information typically included in your credit reports includes:
- The current amount of debt that you have not yet paid back
- Your history of paying bills
- The amount of loan accounts you have, and what types of loans they are
- The amount of time you have had loan accounts open for
- Your credit utilization rate
- Records of any bankruptcies that you may have had, or debts that are in collections
- “Hard” credit inquiries (These are situations when a creditor looks at your credit file in order to determine how much risk there is in loaning you money. They happen when you apply for a loan.)
This information is then combined to calculate your credit score. The formulas can vary a bit, but generally, five factors are weighted in the following order of importance:
- Your history of making payments
- The amount of money you currently owe
- The length of your borrowing history
- The “credit mix” of sources you have borrowed from (e.g., mortgage, credit card, auto)
- Recent hard credit inquiries
The most commonly used type of credit score is FICO. Your FICO credit score will be a number from 300-850. The higher the number, the easier it will be for you to qualify for a loan and receive a favorable interest rate. A score of 720 or above is considered good credit, while a score of below 630 is usually considered poor credit.
How personal loans can hurt your credit
While a personal loan can be a very helpful tool, it’s important that you borrow responsibly and are aware of how personal loans can affect your credit.
So, how do personal loans affect your credit score negatively? Here are a few of the ways a personal loan can negatively impact your credit if you aren’t careful:
Creating a hard credit inquiry
There are major differences between soft and hard credit inquiries.During the loan application process, lenders will run a “hard” check. A hard credit inquiry lowers your credit score for a few months. The more hard inquiries you have on your credit report, the more your score is negatively impacted.
within a one to two week period. When there are several hard credit inquiries within a short period, they’re usually only considered as a single inquiry by credit agencies. This is because they understand that people may apply with multiple lenders and shop around to find the best personal loan terms.
Digging yourself deeper into debt
The amount of debt you have affects your credit score. By taking on a personal loan, you’re taking on more debt. So, if you already have other significant sources of unpaid debt, this can negatively affect your score.
When does a personal loan affect your credit? This happens when you take on more debt than you can handle or if you already have a high debt-to-income ratio. Before taking out a personal loan, consider if you’ll be able to make the payments on time and if the new debt will push your overall debt levels too high.
Risk of late payments and fees
If you fall behind on personal loan payments, this will be noted in your credit report and lower your score. Additionally, failing to make payments on time can mean paying late fees and more interest throughout the loan, causing you to fall further into debt.
Lowers your average credit age
Getting a new personal loan lowers the average age of your credit accounts. This matters because how long you’ve had credit accounts open makes up about 15% of your credit score.
New accounts bring the average age of your credit down, which can temporarily lower your score. Over time, as your new personal loan ages, this effect will lessen, especially if you make all payments on time.
How personal loans help build your credit
So, how do loans affect your credit score positively? If used properly, a personal loan can help you improve your credit. Here are some of the ways that a personal loan can build credit:
Diversify your credit profile
Having a broader range of debt sources can help show your creditworthiness. When you add different types of personal loans to your credit mix, it can boost your score.
You must be able to handle different types of credit responsibly. A personal loan is an installment loan, which is different from revolving credit. Having multiple types in your credit history shows lenders you can manage various forms of credit and debt.
Establishing a credit history
Making payments on time has a positive impact on your credit score. Having a long history of making consistent payments is also good for your credit. A personal loan allows you to do both of these things.
Your payment history makes up 35% of your FICO score, making it the most important factor in your credit score. Making personal loan payments on time every month builds a positive payment history that shows lenders you’re reliable.
Reduce your credit utilization
Your credit utilization ratio is how much of your available credit you use. If you use a personal loan to pay off credit card debt, you’ll reduce the amount of revolving credit you’re using. Since credit utilization makes up a significant portion of your credit score, lowering this ratio by paying off credit cards with a personal installment loan can boost your score.
Hot tip: Try keeping your credit utilization below 30%.
What to consider before getting a personal loan
Before getting a personal loan, there are several things you should think about to make sure it’s the right choice for you and won’t damage your credit:
- Check your credit report: Know where you stand before applying. This helps you understand if you’ll qualify for good rates and prevents unnecessary hard inquiries.
- Shop around: Use a personal loan and payment calculator to compare loan options. Different lenders may offer better rates or terms based on your credit profile.
- Only borrow what you need: Taking a larger loan than necessary means paying more interest and having higher monthly payments.
- Have a repayment plan: Make sure the monthly payments fit into your budget before signing any loan agreement.
- Consider alternatives: Sometimes, a different financial product might be better for your situation, such as a 0% APR credit card for balance transfers.
FAQs
How many points will a personal loan drop my credit score?
When you apply for a personal loan, your credit score might drop a few points at first. This happens because of the hard credit check and adding a new account. The exact number of points depends on your current credit score and history.
People with higher scores might see a bigger temporary drop than those with lower scores. But don’t worry too much about this initial dip. If you make all your loan payments on time, your score will usually bounce back within 2-3 months.
After about six months of on-time payments, your score may end up higher than before you got the loan. This is especially true if you use the loan to pay off other debts or build a positive payment history.
Do all personal loans show up on a credit report?
Most loans from banks, credit unions, and online lenders will show up on your credit reports from the credit bureaus.
However, some loans might not be reported to any credit bureau or may only be reported to 1-2 bureaus. Payday loans, title loans, and loans from small lenders sometimes aren’t reported. Some lenders report to one credit bureau instead of all three.
If you want the loan to help build your credit, ask the lender before you apply: “Do you report loan payments to all three credit bureaus?” If they don’t report to credit bureaus, the loan won’t help build your credit history, even if you make every payment on time.
Does paying back a personal loan quickly affect my credit score?
Paying off a personal loan early has pros and cons for your credit score. On the plus side, you’ll lower your total debt faster, which can help your score. You’ll also save money on interest payments.
However, when you pay off a loan early, you cut short your history of making on-time payments. Since this factor makes up a significant portion of your credit score, you might miss out on some potential credit-building benefits.
Your credit mix might also be affected if the personal loan was your only installment loan. Additionally, some lenders charge early payoff fees, so check your loan agreement first.
If you already have good credit and other active accounts, paying off a personal loan early probably won’t hurt your score much. But if you’re trying to build credit from scratch or improve poor credit, it might be better to make regular payments over the full loan term.
Final thoughts
Personal loans can help you manage your finances when used wisely. While they do affect your credit score in various ways, the impact tends to be positive if you make all payments on time and borrow responsibly. Understanding how loans affect your credit score helps you make better decisions when it comes to your money.
Sun Loan offers personal loans that fit your budget. With our clear terms and helpful resources, we’re here to help when you need extra cash. Our team can answer all your questions about how our loans might affect your credit and guide you through the application process.
