Can a Personal Loan Help My Credit Score?

A personal loan provides a lump sum of money from a lender, which a borrower repays with interest over a set period, typically through fixed monthly installments. These loans are often unsecured, meaning they do not require collateral like a house or car. A credit score is a three-digit number that represents an individual’s creditworthiness, indicating the likelihood of timely bill payments. This article explores how a personal loan can influence one’s credit standing, both positively and negatively, and offers guidance on evaluating if such a loan aligns with credit-building goals.

Components of a Credit Score

A credit score is based on information found in credit reports. The most common credit scoring model, FICO, uses five main categories to calculate a score. Payment history holds the most weight, accounting for approximately 35% of the score, reflecting timely payments. The amount owed, or credit utilization, makes up about 30% of the score, assessing the proportion of available credit currently in use.

The length of credit history contributes around 15% to the score, considering the age of accounts and the average age of all credit lines. New credit, including recent applications and newly opened accounts, accounts for about 10% of the score. The final 10% is attributed to credit mix, which evaluates the diversity of credit types, such as revolving accounts (credit cards) and installment loans (personal loans).

Ways Personal Loans Can Help Credit

Personal loans can positively affect a credit score when managed responsibly. One way is by diversifying the credit mix. If an individual primarily possesses revolving credit, like credit cards, adding an installment loan can demonstrate the ability to manage different types of debt, thus improving the credit mix. Lenders prefer to see experience with various forms of credit.

Another benefit arises from improving credit utilization, especially through debt consolidation. Using a personal loan to pay off high-interest credit card debt can significantly lower the credit utilization ratio on revolving accounts. This ratio accounts for a substantial portion of a credit score, around 30%. By replacing revolving debt with an installment loan, the credit utilization on credit cards decreases, potentially leading to a notable score improvement.

Consistently making on-time, full payments for the duration of the loan term builds a strong positive payment history. This factor is the most influential in credit scoring, often making up about 35% of a score. Each timely payment reported to the credit bureaus contributes to this history, promoting credit score improvement over time.

Ways Personal Loans Can Hurt Credit

While personal loans offer potential benefits, they can also negatively impact a credit score if not managed carefully. Applying for a personal loan triggers a hard inquiry on a credit report, which can cause a small, temporary dip in the score. This inquiry may reduce a score by a few points and remains on a credit report for up to two years, though its impact typically fades within a year. Multiple hard inquiries in a short period can have a more pronounced negative effect.

Taking on a personal loan increases an individual’s overall debt burden, which can affect the “amounts owed” category of a credit score. If the borrower struggles to make payments or takes on additional debt without reducing existing balances, this increased debt load can lead to financial strain and potentially lower credit scores. The impact on the score depends on the total amount of debt relative to income and existing credit.

Missed or late payments are severely detrimental to a credit score, potentially negating any positive effects of the loan. Lenders report payments as late once they are 30 days or more past due, and even a single missed payment can cause a significant drop in a credit score. Such negative marks can remain on a credit report for up to seven years, impacting future borrowing opportunities. Furthermore, a new loan can slightly lower the average age of accounts on a credit report. This effect is generally minor compared to the impact of payment history or credit utilization, but it is still a factor in credit scoring models.

Evaluating a Personal Loan for Credit Building

Considering a personal loan for credit building requires a careful evaluation of one’s financial situation. It is important to assess the ability to consistently repay the loan without financial strain. Lenders consider income and existing debt payments to determine repayment capability, and a higher credit score can lead to better loan terms. Taking on a loan that creates an unmanageable monthly payment can lead to missed payments, which severely damage credit.

Understanding the loan terms is also paramount before committing to a personal loan. This includes the interest rate, any associated fees like origination fees, and the repayment schedule. A longer repayment term might result in lower monthly payments but could lead to paying more interest over the life of the loan. Comparing annual percentage rates (APRs) from different lenders can help determine the true cost of borrowing.

While using a personal loan for debt consolidation can be beneficial for credit, it is crucial to avoid accumulating new credit card debt after consolidation. Other methods exist for building credit, such as secured credit cards or credit-builder loans. These alternatives can also help establish a positive payment history without incurring additional unsecured debt.