How does a personal loan affect your credit score?

A personal loan can be both helpful and harmful to your credit score, depending on your current credit score and repayment habits. While your score will temporarily drop a few points once you apply and will raise your debt levels, a personal loan can help your score grow significantly over time. And, with a low enough personal loan rate, you can finance a necessary purchase at a low cost.

If you’re uncertain as to how a personal loan will impact your credit, look at your budget’s current ability to handle another monthly payment. Your score will drop significantly if you’re late on your payments or don’t make them at all. That being said, a personal loan comes chock-full of benefits, but the potential negative ramifications must also be considered before signing on the dotted line.

How a personal loan can help your credit

A personal loan can benefit you by adding to your credit mix and improving your payment history. If used to consolidate debt, it can also help with your credit utilization ratio.

Payment history

Your payment history accounts for 35 percent of your FICO score — the largest portion. Consistent, on-time payments on your personal loan will increase your score over time. It may take a few months for the benefits to add up, however, and at least a year to offset the negative impact of a hard inquiry from when you apply with a lender.

Credit mix

Your credit score benefits from having a variety of accounts open. Credit mix — or the diversity of your accounts — is 10 percent of your FICO score. If you have two credit cards, for example, a personal loan would expand your credit mix and could help improve your score. The more types of credit you have, the more you prove you are able to handle multiple types of debt.

Credit utilization ratio

Using a personal loan to consolidate credit cards can improve your credit utilization ratio, which makes up 30 percent of your FICO score. That is because credit utilization measures how much of your available credit is compromised by revolving debt.

For example, if you have two credit cards with a total credit limit of $10,000 taking out a personal loan and consolidating $5,000 of the credit card debt will increase the total amount of credit you have access to. Provided you keep your credit card spending low, you will see a decrease in your credit utilization ratio — and an increase in your credit score.

How a personal loan can hurt your credit

A personal loan may lower the total age of your accounts and increase the amount owed portion of your credit – both of which can lower your score.

Missed payments

The same way on-time payments can boost your score, if a lender reports late or missed payments to the credit bureaus, it can lower your credit and stay on your credit report for up to seven years. Unfortunately, there is little to be done when you miss payments. They’ll stick around, and you will need to focus on paying your loan regularly to offset any late or missing payments on your personal loan.

Amount owed

When you take out a personal loan, the amount owed on your credit also increases. This may cause you to see a slight dip in your score. Amount owed is made up of five different factors, and how much you have left on installment loans is part of that. It also considers how much is owed in total across different types of credit accounts.

Hard inquiry

Lenders will run a hard credit pull whenever you apply for a loan. A hard inquiry will temporarily drop your score by as much as 10 points. However, your score should go up again in the following months after you start making payments.

Too many at once can be a bad sign to potential lenders, but fortunately, most will offer a preapproval process so you can avoid a hard hit until you are ready to borrow. You may also be able to apply with several lenders and have them weighted as a single inquiry if you apply within a two week period.

How credit score affects your overall financial health

Your credit score is a measure of how well you handle your financial accounts. This, in turn, helps lenders decide whether they can take on the risk of lending you money. That’s why the higher, the better.

Additionally, insurers, employers and landlords can use your credit profile as a touchstone for reliability in some states. Your credit score may not be directly visible in all cases, but what influences your credit score will be.

In its simplest form, a strong credit background will help you qualify for lower interest rates and more competitive terms. It can also serve as a positive indicator outside of finances. Credit checks and your credit score’s weight are unavoidable truths in the current economy, so it is wise to work to improve it continuously.

When to consider taking out a personal loan

Personal loans are an important tool for financing large expenses like home renovations and debt consolidation. Even though you may see a temporary drop in your score, there are times when a personal loan may be the right choice to improve your credit.

It should be noted, however, that a personal loan is not necessary to build a healthy credit score. These are simply ways it can positively affect your credit.

• You don’t have many open accounts. If you’re just starting out, you may have no credit history. A well-managed personal loan is a good way to start building your history since it will have a term of two to five years — and then stay on your credit report for up to seven once you finish paying it off.
• You only have revolving debts. Credit mix is a small portion of your score, but it still matters. If you only have credit cards, a personal loan can add diversity to your credit mix, showing lenders you are financially responsible enough to handle a variety of debt.
• You want to save money. A personal loan can be used for debt consolidation, among other ways to save money. In some cases, a personal loan may help you lower your average interest rate across accounts and help you avoid the fees charged by credit cards.

The bottom line

Any new debt can be risky to your finances, so consider personal loan alternatives before applying. Be sure you can make your payments each month with a personal loan calculator, and know that a small decrease can easily be overcome by being responsible with your debt.