Do Personal Loans Affect Your Credit?
Discover how personal loans impact your credit. This guide explains their effect on your financial health, from initial application to full repayment.
Personal loans are a common financial tool, typically provided as unsecured installment loans that individuals can use for various purposes, such as consolidating debt or covering significant expenses. Unlike secured loans, they do not require collateral; approval is based on an applicant’s creditworthiness and a promise to repay. Understanding how these loans interact with your credit standing, which is reflected in your credit score and credit report, is important for managing your financial health. Personal loans affect your credit at different stages of the loan process.
Impact of Loan Application
When you apply for a personal loan, lenders typically perform a “hard inquiry” on your credit report. A hard inquiry can cause a slight, temporary dip in your credit score, usually by a few points. While the impact is generally minor, multiple hard inquiries in a short period could signal higher risk to lenders.
Credit scoring models, such as FICO and VantageScore, account for inquiries in their calculations. They are designed to differentiate between a consumer simply shopping for the best rates and one trying to open multiple new credit lines. When you apply for the same type of loan from several lenders within a specific timeframe, often referred to as “rate shopping,” these inquiries are typically grouped and counted as a single inquiry. This helps minimize the negative effect on your score while you compare loan offers.
Impact of Loan Approval
Upon approval and opening of a personal loan, your credit report will reflect the addition of a new account. This new entry can initially reduce the average age of your credit accounts, a factor in credit scoring models. A shorter average age of accounts generally has a modest negative impact on your score, as it suggests a less established credit history. This effect diminishes over time as the account ages.
The principal amount of the personal loan also contributes to your total outstanding debt. While personal loans are installment loans with a fixed repayment schedule, the initial increase in overall debt can be noted by credit scoring models. This affects how much debt you carry relative to your available credit. Managing this debt responsibly by making timely payments will mitigate any adverse effects.
A personal loan can also influence your credit mix, which considers the different types of credit you manage. If your credit history primarily consists of revolving credit, such as credit cards, adding an installment loan can diversify your credit profile. Lenders often view a healthy mix of credit types positively, as it demonstrates your ability to handle various forms of debt responsibly. This diversification can contribute positively to your credit score.
Impact of Loan Management
The most substantial and enduring impact of a personal loan on your credit occurs through your ongoing management of the account, primarily your payment history. Consistently making on-time payments is the most significant factor influencing your credit score and will positively build your credit history.
Conversely, late payments, missed payments, or defaulting on the loan can severely damage your credit score. Payment history accounts for a substantial portion of your credit score, making even a single late payment a notable negative mark. Such negative events can remain on your credit report for several years, affecting your ability to secure future credit at favorable terms.
As you make regular payments, the principal balance of the personal loan decreases over time. This reduction in your overall debt load, even for an installment loan, is generally viewed favorably by credit scoring models. It indicates responsible debt management and a decreasing financial burden.
Once the personal loan is fully paid off and the account is closed, it will typically remain on your credit report for an extended period, often up to 7 to 10 years. During this time, the positive payment history associated with the closed account continues to contribute to your credit score.