How much does a personal loan affect your credit score?
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How much a personal loan affects your credit score depends on your unique financial situation. Learn more. (iStock)
If you’re struggling with high-interest credit card debt, or need cash for an unexpected expense or a large purchase, you might be considering a personal loan. Depending on how you use it, a personal loan can either help or hinder your credit.
This article will cover how a personal loan affects your credit score so you can decide if you should apply for one.
If you decide a personal loan is right for you, Credible makes it easy to compare personal loan rates from multiple lenders, all in one place.
- How personal loans can help your credit score
- How personal loans can hurt your credit score
- How to apply for a personal loan
How personal loans can help your credit score
Taking out a personal loan can have a favorable effect on your credit score, which can help you get approved for loans and other financial products in the future. Some ways a personal loan can benefit your credit score include:
Build a positive credit history
Lenders look at your credit report to find out whether you pay your bills on time or not, as this can indicate how likely you are to repay a new loan. If you take out a personal loan and make your monthly payments in full and on time each month, your credit report will show that and your credit score could improve. Payment history makes up 35% of your credit score.
Create a credit mix
A personal loan can add to your credit mix, which can also raise your credit score. Different types of financial products make up your credit mix, which accounts for 10% of your credit score. A diverse mixture of credit cards, loans, and other accounts can increase your credit score. A personal loan is an installment loan, and paying one off in addition to other financial products can help raise your credit score.
Reduce your credit utilization ratio
Your credit utilization ratio shows lenders how much revolving credit you’re using compared to how much credit you have available. If you don’t use any of your available credit, lenders can’t get an idea of how you handle your debts. If you max out your available credit, lenders might assume you have too much debt to manage, and they may be reluctant to lend to you. Most experts agree that it’s best to use 30% or less of your available credit.
A personal loan can help reduce your credit utilization ratio — because it’s an installment loan, it doesn’t factor into that calculation. If you’re using more than 30% of your available credit on your credit cards, consolidating that debt by taking out a personal loan can lower your credit utilization ratio and help your credit score. Your credit utilization ratio falls under the "amounts owed" FICO category and makes up 30% of your credit score.
Credible lets you compare personal loan rates without affecting your credit score.
How personal loans can hurt your credit score
While personal loans can help your credit score in many ways, they also can negatively affect your credit in certain situations.
Too many hard inquiries can lower your credit score
Using credit wisely is the best way to make it work in your favor. You should only apply for a personal loan when you actually need one for something important, like covering a large expense or consolidating credit card debt.
A hard inquiry happens when a lender accesses your credit report after you apply for a loan. Hard inquiries can remain on your credit report for up to two years. Too many of these inquiries can cause your credit score to go down because it indicates that you might be acquiring new debt. If you apply for many loans — including personal loans — in a short period of time, lenders may see that as a signal you’re having financial trouble and are applying for loans to make ends meet.
Hard inquiries are different from soft inquiries, which don’t affect your credit score at all. Soft credit checks can happen when you or a prospective employer view your credit report, or when you get a pre-approved offer from a lender.
Increase your debt load
Taking out a personal loan could hurt your credit score by adding to the "amounts owed" category of your FICO calculation. Plus, if you use a personal loan to pay off credit card debt but start charging on your credit cards again, you’ll rack up more debt.
Missed payments can decrease your credit score
If you miss just one payment on your personal loan, it can hurt your credit score. In fact, missed or late payments negatively affect your credit score more than any other factor, since payment history accounts for the highest percentage of your credit score (35%).
Before taking out a personal loan, make sure you’re able to pay it back and on time each month, and that you’ll be able to pay your other bills on time too. You can use a personal loan calculator to get an idea of how much a personal loan might cost you each month.
How to apply for a personal loan
While the exact process varies by lender, these are the steps you’ll generally take to apply for a personal loan:
- Check your credit. You’re entitled to a free copy of your credit report each year from the three main credit bureaus (Equifax, Experian, and TransUnion). This saves you from applying for a loan before you’re ready and possibly getting a hard inquiry, which could lower your credit score. If you see any errors on your credit report, dispute them with the appropriate credit bureau.
- Decide how much to borrow. This depends on how much you need and how much you can afford to pay back. Keep in mind that you’ll also pay interest on the loan, and the lender may charge fees that increase the loan’s total cost. It’s best to borrow only the exact amount you need.
- Compare lenders. Comparison shop, looking for lenders that can give you the best terms.
- Get prequalified. Contact the lender of your choosing, and find out how much you might qualify for.
- Apply. Once you prequalify, you can complete a formal loan application. Loan funding times vary by lender, but you may receive your money as soon as the same day you apply in some cases.
If you’re ready to apply for a personal loan, Credible lets you easily compare personal loan rates in minutes.