The 5 Ways a Personal Loan Can Affect Your Credit Score
Certain aspects of taking out a personal loan can help your score, while others can hurt it. In the end, just make sure you’re borrowing responsibly.
Maintaining your credit score is a pretty non-negotiable part of modern day life. While it certainly is possible to live a rich and full life without any credit score whatsoever, it involves quite a bit of extra hassle, and it’s certainly not for everyone. If you want access to credit, you’re going to need to maintain your credit score. It’s as simple as that.
The most common form of credit that people use is credit cards. And that makes sense. Their revolving balances allow people to use them for everyday purchases, all the while accruing points or miles that they can use for future purchases or travel. Like all forms of consumer credit, credit cards can hurt or help your credit score. It all depends on how you use them.
The same holds true for unsecured personal loans. In this post, we’ll give you a detailed overview of how a personal loan can both harm and help your credit score. But what it all comes down to is this: Using credit responsibly is good for your score, while using it irresponsibly is bad.
How your credit score works.
Your credit score is created using information from your credit reports, which track your history of using credit over the past seven years. (Some information, like bankruptcies, will stay on your report for longer.) Your credit reports are compiled by the three major credit bureaus: TransUnion, Experian, and Equifax.
Your credit reports contain a whole range of information, including how much credit you’ve used, what type of credit you have, your total open credit lines, whether you pay your bills on time, the age of your credit accounts, whether you’ve filed for bankruptcy or had liens placed against you, any debt collection actions taken against you, and whether you’ve had any recent hard credit inquiries.
All that information is then fed through a (mostly) secret formula to create your credit score. The most common type of score is your FICO score, which is scored on a scale from 300 to 850. The higher your score, the better. Any score above 720 is generally considered great, while any score below 630 is considered flat-out bad.
The two most important factors in your credit score are your payment history (35 percent) and your total amounts owed (30 percent). Together they make up well over half your score. The other major factors are the length of your credit history (15 percent), your credit mix (10 percent), and your recent credit inquiries (10 percent).
1. How a personal loan affects your payment history.
This is the one category where the effects of your personal loan will depend entirely on your behavior. Assuming that you take out a personal installment loan, which is broken up into a series of small, regular payments, paying your loan on time helps your score while missed or late payments hurts it.
Payment history is the single most important part of your credit score, and one late payment can dramatically lower your score. Meanwhile, it takes months and years of on-time payments to maintain a sterling payment history and to keep your score afloat. If you’re looking to repair your payment history, a personal installment loan (used responsibly) can be a great way to accomplish that.
2. How it affects your amounts owed.
When you take out a personal installment loan, you are adding money to your total amounts owed. This will probably have the effect of lowering your score in the short-term. Adding more debt means that you are increasing your overall debt load, which will likely cause your score to go down. Taking on more debt means an increased risk that you’ll take out too much.
However, if you have a thin credit history (which means you haven’t used much credit), taking out a personal loan will likely help your amounts owed in the long run. Showing that you can manage your debt load is great for your score and sends a signal to potential lenders and landlords that you’re a good bet.
This is one area where credit cards have a leg-up on personal loans. With a credit card, you can help maintain your credit score by never using more than 30 percent of your total credit limit. And when the opportunity arises to raise your credit limits, take it! Personal loans don’t come with a credit limit, so they don’t factor into your “credit utilization ratio.”
3 & 4. What about your length of history and credit mix?
While these factors are less important than your payment history and your amounts owed, they’re still areas where a personal loan can help or hurt your score. With your credit mix, for instance, it will depend on what other kinds of loans or cards you’ve taken out. Does this personal loan make your mix of loans and cards more or less diverse?
For instance, if you have two credit cards and car loan (all of which you are using responsibly), then taking out a personal loan will likely help your score because it means you’re using a new kind of credit. Whereas if you take out an online loan in addition to the two other personal loans you’ve used, your score will probably get dinged. The more diverse your credit mix, the more it will help your credit.
In regards to the length of your credit history, most traditional installment loans come with a multi-year repayment period. So the longer you’ve been paying off your loan, the older the average age of your credit accounts. Older credit accounts help your score because they show that you’ve been able to maintain long-term relationships with your lenders.
There is, however, a weird downside here. When you finally pay off your loan, it could actually cause your score to drop. What?! Well, closing out the account will lower the average age of your open accounts, which will hurt your overall score. This is also why you shouldn’t close old credit cards. The age of those accounts (plus the higher overall credit limit) helps your score!
5. A new personal loan means new credit inquiries.
When you apply for a regular personal loan, your lender will run a hard check on your credit. This means pulling a full copy of your credit report so that they can get a full accounting of your credit history. It’s standard procedure for personal loans, auto loans, and mortgages.
Here’s the downside: Recent credit inquiries will ding your score. Usually, no more than five points or so, and the effect will usually be gone within a year or so. Still, there’s no denying that this part of taking out a personal loan will slightly lower your score. With home and auto loans, multiple inquiries can be bundled together on your score, but this generally doesn’t happen with regular personal loans.
Stay away from no credit check loans.
There’s one exception to this rule, and it has to do with certain types of bad credit loans. Most lenders who serve people with poor credit will not run a hard check on your credit history, which means that your score won’t get dinged. However, many will still run a soft credit check, or pull in data from other alternative sources to get a good idea of your borrowing history before approving your application.
And yet there are no credit check loans out there that—you guessed it—don’t run any sort of credit check whatsoever. Common types of no credit check loans include payday loans, cash advances, and title loans. These types of loans often come with astronomical interest rates and lump-sum repayment terms that can make them incredibly difficult to pay back.
And what’s worse, these lenders typically don’t report payment information to the credit bureaus, so paying the loan off on time won’t help your score at all. But if you default on the loan and get sent to collections, they’ll report the account to the bureaus, which will lower your score. Basically, these loans can’t help your score at all, they can only hurt it.
The most important thing is to borrow responsibly.
As we said up top, the most important part about taking out a personal loan is to use it responsibly. Don’t take out more money than you need, make your payments on time, and make sure your payment amounts fit within your budget. You could even possibly use your personal loan to consolidate higher-interest credit card debt.
Do all that, and your personal loan will end up being a net positive for your credit score. To learn more about maintaining your credit score, check out these other great posts and articles from OppLoans:
- No Credit Card? Here Are 6 Ways You Can Still Fix Your Credit Score
- Should You Cosign That Loan? 5 Things To Consider
- 5 Surprising Ways You Can Hurt Your Credit Score
The information contained herein is provided for free and is to be used for educational and informational purposes only. We are not a credit repair organization as defined under federal or state law and we do not provide "credit repair" services or advice or assistance regarding "rebuilding" or "improving" your credit. Articles provided in connection with this blog are general in nature, provided for informational purposes only and are not a substitute for individualized professional advice. We make no representation that we will improve or attempt to improve your credit record, history, or rating through the use of the resources provided through the OppLoans blog.