Do Personal Loans Help Your Credit Score?

A credit score is a numerical representation of an individual’s creditworthiness, indicating the likelihood of repaying borrowed funds. Personal loans are unsecured installment loans, repaid in fixed amounts over a set period, typically without collateral. These loans can serve various financial purposes, from consolidating existing debt to funding large purchases. Understanding how personal loans interact with credit scores is important for anyone considering this financial product. This article explores the relationship between personal loans and credit scores, detailing potential positive and negative impacts.

Understanding Your Credit Score

Credit scores are three-digit numbers that summarize an individual’s credit risk to potential lenders. The most widely used scoring models are FICO and VantageScore, each evaluating credit behavior. These scores are derived from information within credit reports, which compile an individual’s borrowing and repayment history.

A significant portion of a FICO Score, 35%, is determined by payment history, reflecting consistent on-time payments. Amounts owed, or credit utilization, accounts for 30% of the score. This factor assesses how much revolving credit, such as credit card balances, is used compared to the total available credit limit. Maintaining a credit utilization ratio below 30% is often suggested for optimal credit health.

The length of credit history makes up 15% of a FICO Score, considering the age of accounts. A longer history of responsible credit management contributes positively to this factor. New credit, including recent applications and newly opened accounts, impacts 10% of the score. The final 10% is influenced by credit mix, which evaluates the diversity of credit types, such as installment loans and revolving credit.

VantageScore models also consider these broad categories, though with varied weightings. Payment history is highly influential for VantageScore, accounting for 40% of the score. Individuals new to credit or with few active accounts may have a “thin credit file,” which can make it challenging to generate a robust score, potentially limiting access to credit or favorable terms.

How Personal Loans Influence Credit Factors

Obtaining and managing a personal loan can affect the various components of a credit score. The impact begins with the application process and continues throughout the repayment period.

Payment history, the most heavily weighted factor in credit scoring, is directly influenced by a personal loan. Making consistent, on-time payments demonstrates responsible financial behavior and builds a positive credit history. Conversely, missing payments can severely damage credit scores. A single late payment can lead to a substantial score drop, 50 to over 100 points, especially for individuals with excellent credit. Negative marks can remain on a credit report for up to seven years.

A personal loan can contribute to a diversified credit mix. If an individual’s credit profile primarily consists of revolving credit like credit cards, adding an installment loan can show lenders the ability to manage different types of debt, which can positively influence the credit mix factor.

Personal loans do not directly impact revolving credit utilization. However, using a personal loan for debt consolidation can indirectly benefit credit utilization. By paying off high-balance credit cards with a personal loan, the revolving utilization ratio on those cards decreases significantly, which is favorable for credit scores. While revolving utilization may decrease, the overall amount of debt increases with the new personal loan.

Applying for a personal loan results in a hard inquiry on a credit report, which can cause a small, temporary dip in credit scores, 5 to 10 points. This effect is short-lived, lasting up to 12 months, though the inquiry itself remains on the report for two years. Opening a new loan account can slightly reduce the average age of all credit accounts, which might have a minor, temporary effect on the length of credit history, particularly for those with limited overall credit history.

Strategic Considerations for Personal Loans

While personal loans can be a tool for financial management, careful consideration is necessary to align them with credit-building goals. Understanding when a personal loan might offer benefits versus when it could pose risks is important for making informed decisions.

One benefit of a personal loan is debt consolidation. By using a personal loan to pay off multiple high-interest credit card balances, individuals can reduce their revolving credit utilization. This strategy can also simplify debt management by consolidating several monthly payments into a single, predictable installment.

For individuals with a “thin credit file,” a personal loan can establish a positive tradeline. Consistent, on-time payments on an installment loan can demonstrate creditworthiness and help build a robust credit history. Securing a personal loan can diversify a credit portfolio by adding an installment account alongside any revolving credit lines, which can contribute to the credit mix factor.

However, there are also risks that can negatively impact credit scores. Missing payments on a personal loan carries severe consequences. A single late payment can significantly reduce a score. Taking on unnecessary debt solely for credit building can lead to financial strain.

Personal loans can come with varying interest rates and fees. Interest rates can range widely, from 6% for borrowers with excellent credit to over 30% for those with lower scores, with the average falling between 12% and 26%. Some lenders also charge origination fees, which typically range from 1% to 10% of the loan amount, and can be as high as 12%, deducted from the principal at funding. These costs can make a loan more expensive and harder to repay if not carefully evaluated.

Before applying for a personal loan, assess one’s financial situation, including the ability to afford monthly payments. Comparing interest rates and terms from multiple lenders is a step to secure favorable conditions. If the primary objective is solely credit improvement, exploring alternatives like secured credit cards or credit-builder loans may be more appropriate and less risky for establishing a positive credit history.