Does a Personal Loan Hurt Your Credit?
Understand how personal loans affect your credit. Learn the factors that determine if a loan strengthens or weakens your financial standing.
A personal loan provides a lump sum of money from a lender, which borrowers repay in fixed monthly installments over a set period. These loans are often unsecured, meaning they do not require collateral. Personal loans offer flexibility for various purposes, including consolidating high-interest debt, funding major purchases, or covering unexpected expenses. Understanding how a personal loan impacts your credit is important, as the effects depend on several factors throughout the loan’s lifecycle.
The Immediate Credit Score Impact
Applying for a personal loan involves a “hard inquiry” on your credit report. This occurs when a lender checks your credit history to assess creditworthiness before making a lending decision. A hard inquiry can cause a small, temporary dip in your credit score, usually by a few points, such as 3 to 5 points. While a hard inquiry remains on your credit report for up to two years, its effect on your credit score diminishes after about one year.
Once approved, opening a new loan account can also temporarily influence your credit score by affecting the average age of your credit accounts. Credit scoring models consider the length of your credit history, and adding a new account can reduce this average. This impact is minor and short-lived, with scores often rebounding within a few months as you manage the new debt responsibly. The initial dip from a hard inquiry and new account is less significant than the long-term effects of repayment behavior.
The Ongoing Impact of Loan Repayment
Payment history is the most influential factor in credit scoring, accounting for approximately 35% of a FICO score. Consistently making on-time payments on a personal loan demonstrates responsible financial behavior, which positively contributes to your credit score over time. Each timely payment reported to credit bureaus helps build a positive credit history. This consistent behavior signals to lenders that you are a reliable borrower.
Conversely, missed or late payments can severely harm your credit score. Lenders report payments as late once they are 30 days or more past the due date. A single late payment can cause a significant drop in your score, and its negative impact can remain on your credit report for up to seven years from the original delinquency date. Multiple missed payments or allowing an account to go into default will lead to substantial and lasting damage to your credit profile.
Successfully paying off a personal loan demonstrates positive credit management. While eliminating debt is financially beneficial, a temporary, minor dip in your score may occur immediately after paying off an installment loan. This fluctuation is often due to changes in your overall credit mix or the average age of your accounts once the loan account is closed. However, the long-term benefit of a positive payment history and reduced debt outweighs any brief score decrease.
How Personal Loans Affect Your Credit Profile
A personal loan, an installment loan, can influence the composition of your credit profile. Credit scoring models consider your “credit mix,” which refers to the different types of credit accounts you manage, such as revolving credit and installment loans. Adding an installment loan to a profile primarily consisting of revolving credit can diversify your credit mix, which may be viewed favorably by credit scoring models, potentially improving your score.
Personal loans do not directly impact credit utilization in the same way revolving credit does, as they are not revolving lines of credit. However, a personal loan can indirectly affect your credit utilization ratio if used for debt consolidation. For example, using a personal loan to pay off high-balance credit cards reduces your credit card utilization, which is a significant factor in credit scoring. Lowering this ratio can lead to a positive impact on your credit score.
Monitoring Your Credit After Taking a Loan
After taking out a personal loan, regularly monitoring your credit report is important. Federal law entitles you to a free copy of your credit report from each of the three major nationwide credit bureaus (Equifax, Experian, and TransUnion) weekly via AnnualCreditReport.com. Reviewing these reports helps you track how the loan impacts your credit and ensures accuracy.
Credit scores are dynamic and reflect the information on your credit reports. Your score will fluctuate based on new activity, payment behavior, and the aging of your accounts. Online tools and services also offer free access to your credit score, often updated monthly, which can help you observe changes. These tools can provide insights into the factors influencing your score.
When reviewing your credit reports, look for accurate reporting of your personal loan, including the loan amount, payment history, and current balance. Promptly dispute any errors or discrepancies you find, such as incorrect payment statuses or unauthorized accounts. Ensuring the information is correct is crucial, as inaccuracies can negatively affect your credit score and financial standing.