Do Personal Loans Hurt Your Credit Score?
Personal loans and your credit score: understand their intricate relationship. Discover how they impact your financial profile over time.
Personal loans and your credit score: understand their intricate relationship. Discover how they impact your financial profile over time.
Personal loans, often sought to cover significant expenses or consolidate existing debt, can have a complex relationship with an individual’s credit score. These loans are typically unsecured, meaning they are not backed by collateral, and involve fixed monthly payments over a set period. The way a personal loan interacts with your credit profile is not straightforward; its effect can be either beneficial or detrimental, largely depending on how it is managed.
When an individual applies for a personal loan, a “hard inquiry” is made on their credit report. This occurs when a lender checks your credit history. A single hard inquiry can cause a small, temporary dip in your credit score, usually by fewer than five points. These inquiries remain on your credit report for up to two years, though their impact generally fades after about 12 months.
Once approved, the personal loan appears as a new account on your credit report. Adding a new loan can slightly lower the average age of all your credit accounts. The length of your credit history accounts for 15% of your FICO score, so a newer account can dilute the overall average, especially for individuals with a shorter credit history.
However, a personal loan, an installment loan, can positively contribute to your “credit mix.” Credit mix accounts for 10% of a FICO score and demonstrates your ability to manage different types of credit, such as revolving accounts (like credit cards) and installment accounts. If your credit profile primarily consists of revolving credit, adding an installment loan can show a more diverse and responsible credit portfolio, potentially boosting your score over time. While the initial loan amount adds to your overall debt, its direct impact on credit scoring models like FICO is less pronounced than factors like payment history or credit utilization for revolving accounts.
The primary effect of a personal loan on your credit score stems from your repayment behavior. Payment history is the largest factor in FICO score calculations, making up 35% of the score. Consistently making on-time payments each month demonstrates financial responsibility and builds a positive credit history, leading to gradual improvement in your credit score over the loan’s term.
Conversely, late payments can damage your credit score. A payment reported as 30 or more days past due can lower your score. The negative impact intensifies with longer delays, such as 60 or 90 days past due. These derogatory marks remain on your credit report for up to seven years from the original delinquency date. Even if the payment is eventually made, the record of the delinquency persists, though its impact on the score lessens over time.
Unlike revolving credit, installment loans do not have a credit utilization rate. However, as the principal balance of the personal loan is paid down, the overall reported debt decreases. This reduction in the amount owed is viewed favorably by credit scoring models, contributing to a positive credit trajectory.
While not directly factored into credit scores, your debt-to-income (DTI) ratio is influenced by a personal loan and can affect future lending decisions. Lenders consider DTI to assess your capacity for taking on additional debt. A lower DTI, around 36% or below, is preferred by many lenders, though some may approve loans with a DTI up to 43% or even 50% for certain programs. Successfully paying off the personal loan as agreed is a strong indicator of responsible credit management, which can enhance your overall credit profile.
A personal loan can also be used strategically, such as for debt consolidation, to indirectly benefit your credit score. By using a personal loan to pay off high-interest credit card debt, you can reduce your revolving credit utilization, a major factor in credit scoring. This approach can also simplify payments, potentially leading to better payment habits. Such strategic use is only advantageous if the new personal loan is managed responsibly with consistent, on-time payments.