Do Personal Loans Affect Credit Utilization?

Personal loans impact credit utilization, a significant element in determining one’s credit score. This article clarifies how personal loans interact with credit utilization and their broader influence on your credit profile.

Understanding Credit Utilization

Credit utilization represents the amount of revolving credit you are currently using compared to your total available revolving credit. It is expressed as a percentage and is a major factor in credit scores. To calculate your credit utilization ratio, you add up the balances on all your revolving accounts and divide that sum by the total credit limits across those accounts. For instance, if you have $1,000 in balances on credit cards with a total credit limit of $5,000, your utilization is 20%.

This calculation applies primarily to revolving credit accounts, such as credit cards or lines of credit, which allow you to borrow, repay, and borrow again up to a set limit. A lower credit utilization ratio is viewed favorably by lenders and contributes to a healthier credit score. Experts recommend keeping overall credit utilization below 30% for good credit standing.

Personal Loans as Installment Credit

A personal loan is a type of installment credit, differing from revolving credit. With an installment loan, you receive a fixed sum of money upfront, and you repay it over a predetermined period through regular, fixed payments. Once the loan is fully repaid, the account is closed. Examples of installment credit include mortgages, auto loans, student loans, and personal loans.

Because personal loans involve a fixed amount and set repayment, they do not have a revolving credit limit like credit cards. Consequently, the outstanding balance of a personal loan does not directly factor into the calculation of your revolving credit utilization ratio. This means that taking out a personal loan will not, by itself, increase your credit utilization percentage.

Overall Credit Score Impact of Personal Loans

While personal loans do not directly affect revolving credit utilization, they influence other components of your credit score. One factor is your credit mix, which considers having different types of credit, such as both revolving and installment accounts. A diverse credit mix can demonstrate your ability to manage various forms of debt responsibly, potentially benefiting your score.

Payment history holds significant weight in credit scoring, accounting for a large portion of your score. Making consistent, on-time payments on a personal loan positively contributes to your payment history, a major determinant of creditworthiness. Conversely, missing payments can significantly harm your score.

Applying for a personal loan involves a hard inquiry on your credit report, which can cause a small, temporary dip in your score, usually less than five points. This inquiry remains on your report for up to two years but impacts your score for about 12 months. A new personal loan also affects the average age of accounts, as it introduces a newer account to your credit history, which can slightly lower the overall average.

The total amount owed on all accounts, including installment loans, is considered by credit scoring models. While this does not relate to utilization, managing the balance of your personal loan by making regular payments reduces your total debt burden, which can be viewed positively over time.