How Does a Personal Loan Affect Your Credit Score?
Personal loans affect your credit score for several reasons.
Personal loans serve as a versatile financial tool that could help you cover a large purchase, streamline debt payments, or cover unexpected costs that pop up. Your credit score could impact your ability to get a loan, and having a loan may also impact your score.
Before you apply, let’s talk about the affect a personal loan could have on your credit score.
The impact of a personal loan on your credit score depends on your financial situation.
When you take out a personal loan, your score may drop a few points initially, but making on-time payments could raise your score over time.
Your credit score could take a hit if you make late payments or miss them entirely, as lenders usually report these actions to credit bureaus.
What Is a Personal Loan?
Personal loans are unsecured debts. If you’re in the market for a personal loan, you’re most likely going to borrow from a bank, but other types of financial institutions offer them too. Unlike other kinds of loans, personal loans usually don’t have many restrictions on how the proceeds may be used. So, this means you could use the loan to cover unexpected emergency costs, home renovations, debt payments, and more.
Unlike car and home loans, personal loans typically have short repayment terms with most lenders offering terms between one and five years. The exact terms of your loan depends on your lender and their requirements
Since these loans are unsecured, meaning they’re not backed by collateral the way a home loan or car loan is, lenders pay really close attention to your credit score when you apply. Strong finances and a good credit score may increase your chances of being approved and receiving favorable rates.
Personal Loans and Your Credit Score
When it comes to your credit score, a personal loan has the potential to have a positive impact on your credit—assuming you manage your loan wisely. Of course, a few missteps, especially with payments, could have a negative impact on your score.
Let’s examine how each stage of the personal loan process could impact your credit score.
Does Researching a Personal Loan Affect Your Credit Score?
If you’re in the researching phase for a personal loan and you’re reviewing pre-qualified offers or considering different loan options, your score won’t be impacted as long as lenders are performing a soft credit check.¹
Soft credit checks don’t affect your credit score and are only used to give lenders an idea of your financial situation. As you review loan options from different lenders or for different amounts, these soft inquiries give you an idea of the rates you may pay without impacting your credit score as long as you don’t formally apply for the loan.²
Does Applying for a Personal Loan Affect Your Credit Score?
Once you submit an application for a personal loan, that’s when your credit score could be affected. At this point, the lender runs a hard credit check because they’re making a lending decision. Hard credit checks remain on your credit report for two years and may cause your score to drop around 5 points.³
How Could a Personal Loan Help Your Credit Score?
Personal loans may help improve your credit score in several ways.⁴ The first is by diversifying your credit mix. Your credit mix refers to the types of credit, such as installment loans or credit cards, you have. The more types you have (and stay current on), the stronger your credit situation may appear to lenders.
The second way is by helping you establish or strengthen your credit history. When you make payments on time, those payments get reported to the credit bureaus and, over time, show a history of good credit habits, which could help increase your score.
Personal loans may also help you lower your credit utilization ratio over time. This ratio refers to the amount of your total credit limit that you’re using (i.e., the debt available vs. the debt outstanding). If you take a personal loan to consolidate credit card debt, you’re potentially setting yourself up to pay down debts faster. When you do that, your credit ratio utilization goes down faster too, creating an opportunity to possibly boost your score.
How Could a Personal Loan Hurt Your Credit Score?
A personal loan on its own may not hurt your credit score, but if you misuse this financial tool, you may see a drop in your score.
One example of misusing personal loans happens when the borrower doesn’t change their spending behavior. For example, let’s say you take out a personal loan to consolidate your credit card debt. But continue spending on your cards and max them out again. The result is that you would owe both credit card payments and a loan payment, which is not moving you toward improved financial wellness and probably isn’t going to improve your score.
Another example of misuse is when borrowers can’t make the payments on a new loan. For example, when you take out any new loan, you’re now on the hook for an additional payment each month. Since your payment history is a major factor in calculating your credit score, it’s important to only take on debt you’re able to repay. A late or missed payment may cause your score to drop by up to 180 points!⁵
How Does Paying off a Personal Loan Impact Your Credit Score?
You’ve made the final payment on your loan and are about to celebrate when you get a notification that your credit score has dropped. What happened?
As strange as it might sound, paying off a personal loan could actually cause your score to go down.⁶ This may happen for various reasons, such as:
Changing Your Credit Mix. When you pay off the personal loan, the loan is no longer part of your credit mix and could cause your score to drop.
Flexibility with Proceeds. Personal loans allow you to use the proceeds for almost anything, from debt consolidation to purchasing a new appliance to renovating your basement.
Altering Your Average Account Age. Your credit score is impacted by how long you’ve been using credit. When you pay off a loan or close a line of credit, that account is no longer one of your debts. As a result, the average age of your remaining accounts may drop, which could also cause your score to decrease.
Impacting Your Utilization Ratio. Your credit utilization ratio may have a significant impact on your credit score. This ratio is calculated by comparing your balances on active accounts to your credit limit or the initial loan amount. When you pay off your personal loan, you may see a score drop if the loan had a low balance or a low balance to limit ratio.
That said, the score drop after paying off a loan is typically temporary and you should see your score rebound within a few months.
Reasons to Take Out a Personal Loan
So, when should you consider applying for a personal loan? Here are two common scenarios where a personal loan may be the right move for you.
Save Money on Interest: Whether you need to cover the cost of a home renovation or cover emergency expenses like a large hospital bill, personal loans tend to have lower rates than credit cards. These rates are represented as Annual Percentage Rate (APR). In November 2023, average personal loan rates were around 11.53% APR⁷ compared to credit card rates as high as 30.01% APR,⁸ meaning personal loans may save you money in the long run.
Diversify Your Credit: Whether you have a short credit history or have mostly relied on credit cards, a personal loan could help diversify your credit mix and establish a history of on-time payments. Having a diverse credit mix means you have both installment and revolving credit, showing you’re able to handle both types of debt repayment.
Personal loans may offer an opportunity to boost your credit score when used strategically. By making on-time payments and establishing healthy financial habits, your credit score may rise over time.
Learn more about Jenius Bank personal loans today.