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A personal loan can be a convenient way to borrow money or consolidate debt, but it's important to understand the effect a personal loan can have on your credit scores. Its potential impacts begin when you apply for a loan and a hard inquiry appears on your credit report. Loan approval then increases the amount of debt you owe, and finally there's the potential that you'll miss a bill and pay late or default.
That doesn't have to prevent you from pursuing a personal loan, however. After all, responsibly managing a personal loan can actually help you improve your credit over time. Before borrowing, understand and plan for the potential credit impact so that you can protect your score throughout the process.
How a Personal Loan Can Hurt Your Credit
When you apply for any type of credit, including a loan or credit card, the lender typically requests access to your credit report so it can assess the risk of nonpayment based on your credit history. That request for access leads to a hard inquiry on your credit report, which will remain there for up to two years. A hard inquiry can trigger your credit scores to drop slightly, but they're likely to recover within a few months to one year—and the impact will decrease with time as you continue to make on-time bill payments and show other positive credit behavior.
A personal loan can also hurt your credit if you wind up missing even a single monthly payment. A missed payment will have a much more significant impact on your credit than the other factors, since payment history accounts for 35% of your FICO® Score☉ . Even if you're able to stay on top of your personal loan payments, though, they could stress the rest of your finances and put you at greater risk of credit score harm caused by late payments on your other accounts.
Finally, the added debt from a personal loan contributes to the "amounts owed" category in FICO® Score calculations, which accounts for 30% of your FICO® Score. Merely owing money doesn't mean you're considered a risky borrower—and it won't sink your score—but high balances on credit accounts and the presence of loans with large balances left to pay off can negatively impact your credit. Additionally, while your debt-to-income ratio (DTI) isn't included in credit score calculations, a high DTI can make it difficult to qualify for certain types of loans, like mortgages, where lenders look specifically at DTI when making credit decisions.
Ways to Limit a Personal Loan's Negative Credit Impact
If you ultimately decide that a personal loan is the right choice for your finances, there are steps you can take to limit its effect on your credit score:
- Apply for loans within a two-week period. The FICO® Score algorithm will recognize that you're rate shopping, or comparing rates across multiple loans within the same category, if you submit applications within a specific time frame. That period is 14 days for older FICO® Score versions and 45 days for newer versions. To be safe, submit all loan applications within the 14-day time frame, since lenders may use an older version of the FICO® Score to assess your creditworthiness.
- Make all payments on time. Paying every bill on time is essential to maintaining a strong credit score. The same is true for your new personal loan. If 100% of your personal loan payments are made on time, the loan can help future lenders see that you can be trusted to follow through on your financial obligations.
- Pay off the loan in full. In addition to making on-time payments, it's important to make every payment until the load is paid off. Paying off a personal loan early won't necessarily improve your credit score, however. Once paid off, the account will be considered closed, and your score won't benefit as much from your on-time payment history as it would if the account were still open and being managed responsibly.
How a Personal Loan Could Help Your Credit
Despite the risks, your personal loan account may wind up helping you improve your credit. First, it adds positive payment history to your credit report, assuming you regularly pay on time. It can also add to your credit mix, especially if you previously had only credit cards and a personal loan is the first installment loan in your name. Credit scoring models reward borrowers who are able to capably oversee multiple types of credit.
A debt consolidation loan can also help your credit. This is a type of personal loan that combines multiple debt balances into one loan, ideally at a lower interest rate. It may also reduce your credit utilization, which is an important scoring factor that compares your revolving credit balances with your credit limits. High balances can drive up your credit utilization and hurt your credit, but your credit utilization on those cards will decrease to 0% when you transition those debts to an installment loan with a debt consolidation loan. That can have a positive effect on your credit score.
Deciding on a Personal Loan
Negotiating the pros and cons of getting a personal loan for your credit is an important part of the decision-making process. You may decide that it's not the right time to add a hard inquiry to your credit report, or you may realize that the added monthly debt payment won't work with your current monthly budget.
Once you've decided to apply for a personal loan, choosing the right one based on interest rate, monthly payment and other features is the next step. When you start paying down a personal loan, keep in mind that it's an opportunity to pick up positive credit history, and it's in your power to make the loan work for you. If you need help finding a personal loan that works for you, Experian CreditMatch™ can pair you with personalized loan offers.