Does a Personal Loan Affect Your Credit Score?

A personal loan provides a lump sum of money that you repay over a set period, typically through fixed monthly installments. These loans are usually unsecured, meaning they do not require collateral like a house or car. While a personal loan can offer financial flexibility, its impact on your credit score can be both immediate and long-lasting, influencing your financial standing positively or negatively.

How Applying for a Personal Loan Affects Credit

Applying for a personal loan initiates a “hard inquiry” on your credit report. This occurs when a lender reviews your credit file to assess your creditworthiness. A single hard inquiry results in a small, temporary decrease in your credit score, typically by five to ten points. These inquiries remain on your credit report for up to two years, though their impact diminishes after 12 months.

In contrast, a “soft inquiry” does not affect your credit score. Soft inquiries occur when you check your own credit score or when a potential lender pre-approves you for an offer. For certain loans like mortgages, auto, or student loans, multiple hard inquiries within 14 to 45 days are treated as a single inquiry by credit scoring models. This allows consumers to shop for the best rates without multiple negative impacts. This grouping benefit does not extend to credit card applications.

How Managing Your Personal Loan Impacts Credit Over Time

The way you manage a personal loan after approval significantly influences your credit score. Payment history is the most influential factor in credit scoring, accounting for about 35% of your FICO Score. Consistently making on-time payments demonstrates responsible financial behavior and can improve your credit score. Conversely, missed or late payments, especially those reported 30 days or more past their due date, can damage your score. These negative marks can remain on your credit report for up to seven years.

A personal loan, being an installment loan with fixed payments, can also diversify your credit mix. Credit scoring models consider the variety of credit types you manage, and adding an installment loan alongside revolving credit, like credit cards, can be viewed positively. While credit mix accounts for a smaller portion of your score, around 10% of the FICO Score, it can contribute to a stronger credit profile. However, opening new accounts solely to improve credit mix is not recommended.

Personal loans do not directly affect your credit utilization ratio in the same way revolving credit does, as they are not a line of credit you continually draw from. However, using a personal loan for debt consolidation can indirectly benefit your credit utilization. By using the loan to pay off high-interest credit card balances, you can lower your credit card utilization, which is a significant factor in credit scoring. Maintaining a credit utilization ratio below 30% is advised for healthy credit.

Finally, a new personal loan can slightly impact the average length of your credit history. Since a new account is added, the overall average age of your credit accounts might decrease, which could result in a minor dip in your score. This effect is temporary, and as you make consistent payments, the account matures and contributes positively to your credit history. Length of credit history accounts for 15% of your FICO Score.

Using Personal Loans to Build Credit

Leveraging a personal loan to improve your credit requires disciplined financial management. The most effective strategy involves consistently making all loan payments on time. Timely payments are reported to credit bureaus and establish a positive payment history, which is the most influential factor in your credit score. Setting up automatic payments directly from your bank account can help ensure that you never miss a due date.

Borrow only an amount you can comfortably repay. Taking on excessive debt increases the risk of missed payments, which can damage your credit. Responsible repayment demonstrates creditworthiness, showing your ability to manage debt reliably.

A personal loan can also be a strategic tool for debt consolidation, particularly if you have high-interest credit card debt. By transferring revolving credit balances to an installment loan, you can lower your credit card utilization, which leads to an improved credit score. Regularly checking your credit reports for accuracy allows you to identify and dispute any errors.