How Does a Personal Loan Affect Your Credit Score?

A personal loan (or any other form of credit) can hurt your credit if you manage it poorly. But if you handle a personal loan responsibly, there are several ways it could promote long-term credit score improvement. The extent of that improvement will depend on your credit history and the other debts detailed in your credit reports. Read on for details.

What Is a Personal Loan?

When you take out a personal loan, the lender provides you with a lump sum of cash that you can use for virtually any purpose you choose, with the understanding that you’ll pay it back—with interest and possible fees—in a series of regular installment payments.

Unlike mortgages and auto loans, most personal loans are unsecured debts—that is, they are not backed by collateral such as a financed car or home. For this reason, personal loans may carry somewhat higher interest rates than car loans or other secured credit, but their annual percentage rates (APRs) are typically far lower than those for credit cards.

How Applying for a Personal Loan Affects Your Credit

Applying for a personal loan affects credit scores much the same way applying for a credit card does: The application triggers a credit check known as a hard inquiry, which typically causes a small, temporary decline in your credit score. If your application is approved and you receive the loan, your credit score could drop still a few more points, as the new credit line decreases the overall average age of your accounts. There are, however, several ways a personal loan can help your credit, if managed responsibly.

How Personal Loans Can Help Your Credit

When managed properly, taking out a personal loan can help you improve your credit in several ways.

Lower Credit Utilization Rate

Using a personal loan for debt consolidation—specifically, applying funds borrowed at a relatively low interest rate to pay down higher-interest credit card debt—could improve your credit scores. That’s because reducing credit card balances also reduces your credit utilization rate, or the percentage of available credit you’re using.

Your credit utilization rate is responsible for about 30% of your FICO Score, and utilization rates greater than about 30% tend to do more significant damage to your scores. So using a personal loan to pay down balances that exceed that amount could help your scores.

Additional Positive Payments

The factor with the greatest influence on credit scores is debt payment history, which is responsible for about 35% of your FICO Score, the score used by 90% of top lenders.

A single payment that’s late by 30 days or more can do serious harm to your credit scores, but every timely payment you make on a personal loan (or any of your other debts) adds to your positive payment history and helps promote credit score improvement.

Increased Credit Mix

When lenders evaluate potential borrowers’ creditworthiness, they like to see evidence of experience with multiple accounts and different kinds of debt, including a combination of revolving credit and installment loans. This experience is summed up in a credit scoring factor called credit mix, which accounts for about 10% of your FICO Score.

If a new personal loan increases the number and variety of active credit accounts in your credit reports—especially if all you have right now are credit cards—it could enhance your credit mix and lead to credit score improvement.

How Personal Loans Can Hurt Your Credit

Like any debt, improperly managing a personal loan can cause credit damage that can be difficult to recover from.

Inquiry-Related Credit Score Drops

As discussed above, a hard inquiry can cause your credit scores to drop slightly when you apply for new credit, and scores typically dip a few more points when you are issued a new loan.
Note that the FICO Score and VantageScore® credit scoring systems accommodate rate shopping for installment loans by treating applications to multiple lenders within a short time period—typically 14 to 45 days—as a single event. (By contrast, hard inquiries triggered by multiple credit card applications within a short timespan can have a cumulative negative effect on credit scores.)
Another convenient way to shop for personal loan offers and rates is to use prequalification, a process that uses a soft inquiry, which does not affect credit scores, to estimate the interest rate and loan amount you can expect in a loan offer. A number of companies, including Experian, enable prequalification with multiple personal loan providers in a single step to simplify the comparison process.

Increasing Overall Debt

When you take out a personal loan, you add to your total debt load, and that can have a negative impact on your credit scores. If you’re using some or all of the borrowed funds for debt consolidation, you may offset that by reducing balances on other loan or credit card accounts—an impact that could take a month or two to be reflected on your credit reports and credit scores, but which could eventually lead to net score improvement. If you’re using the loan for other purposes, your scores could improve more slowly, as you pay down the personal loan balance and the balances on your other accounts.

Managing Additional Payments

When you take on a new personal loan, you also add a new bill to your monthly financial schedule. That could bring challenges to household budgeting or bookkeeping. Mishandling those challenges by making a late payment or missing one altogether could mean costly late fees and significant damage to your payment history and, as a result, your credit scores. Making every effort to avoid late payments, such as setting up autopay, can make it more likely your new loan will benefit your scores in the long run, rather than hurt them.

What Credit Score Do You Need for a Personal Loan?

Credit scores can play a significant role in determining your eligibility for a personal loan, and they also can influence the maximum amount a lender is willing to lend you and the interest and fees you’ll be charged on the loan. The higher your credit score, the better the borrowing terms you’ll likely get.
Lenders can set minimum credit score requirements for their loans however they choose, but the FICO Score and VantageScore scoring models identify score ranges that denote different degrees of creditworthiness.

Credit Score Ranges, FICO and VantageScore
FICO Score VantageScore
Exceptional: 800-850
Very good: 740-799
Good: 670-739
Fair: 580-669
Poor: 300-579
Superprime: 781-850
Prime: 661-780
Near prime: 601-660
Subprime: 300-600

It may be possible to get a personal loan with a FICO Score in the fair range or a VantageScore in the near prime range, but you can expect to pay higher interest rates and fees. A FICO Score that falls in the good range or a VantageScore in the prime range will likely mean a wider range of personal loan options at more affordable borrowing terms. If your scores fall in the higher ranges of either score, you may be offered even more favorable deals on personal loans and other types of credit.

Learn more >> The Complete Guide to Understanding Credit Scores

When to Consider a Personal Loan

Reasons for taking out personal loans tend to be, well, personal. Every need is at least a little bit different, but here are some circumstances in which a personal loan could make sense:

  • Managing high-interest debt: Credit card interest rates tend to be steep. Using a relatively low-interest loan to pay down card balances can save you money and help you lower the cost of eliminating credit card debt.
  • Covering emergency costs: A crisis, such as a medical emergency or an extended unplanned stay away from home with a loved one, can quickly drain your household emergency fund and put a strain on your credit cards. In some cases, it may be less expensive and more convenient to borrow a lump sum you can use as needed to get through a difficult stretch.
  • Making home repairs or improvements: Unlike a home equity loan or home equity line of credit (HELOC), a personal loan doesn’t use your home as collateral. So, financing a remodel, roof replacement or other home project with a personal loan avoids putting your house at risk (but it might come with a heftier interest rate).
  • Experiencing once-in-a-lifetime adventures: The use of personal loans for weddings, safaris, retirement vacations and other big events is not unheard of, but it’s something you should consider carefully before taking on the debt. These expenses are often better paid for out of savings, but if you know you can cover the loan payments, a personal loan could be an option. On the other hand, if finances are tight, even the greatest of escapes won’t be worth it if you return to insurmountable bills.

Alternatives to Personal Loans for Building Credit

If you’re looking for ways to build credit, a personal loan can help under the right circumstances, as described above. Here are some other options you can pursue to help improve your credit scores:

  • Credit-builder loan: A credit-builder loan can bolster credit scores and help you save some money. You borrow an amount ranging from several hundred to several thousand dollars, and the sum is placed in a special interest-bearing account that you cannot touch for the time being. If you complete your payments (with interest), you build up a payment history that can help your credit scores, and the money in the account is yours to use as you see fit.
  • Credit-building debit card: The Experian Smart Money™ Digital Checking Account & Debit Card can help you build credit without debt by linking to Experian Boost, which gives you credit for eligible bill payments after three months of payments. See terms at experian.com/legal.
  • Secured credit card: If you’re working to establish credit as a new user or rebuilding damaged credit, a secured credit card can help. You put down a cash deposit that usually serves as your credit limit. If you don’t pay your bills on time, your deposit is used to make your payments. By making charges and repaying them on time, you can amass a positive payment history that will tend to improve your credit scores.

The Bottom Line

Whether it’s for debt consolidation, emergency expenses or other uses, a personal loan has the potential to help (or hurt) your credit scores. If you manage it responsibly and keep up with all your other debt payments, a personal loan can be a useful tool in your credit arsenal.

The post How Does a Personal Loan Affect Your Credit Score? appeared first on Experian’s Official Credit Advice Blog.

https://www.experian.com/blogs/ask-experian/how-does-a-personal-loan-impact-your-credit/

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