Does Getting a Personal Loan Hurt Your Credit Score?
Understand the nuanced relationship between personal loans and your credit score, covering initial application effects and long-term credit improvement.
A personal loan, an unsecured installment loan used for various financial needs, can influence a credit score in several ways. The effect is not always straightforward, encompassing both temporary declines and potential long-term benefits. Understanding these dynamics involves recognizing how different aspects of a loan interact with credit scoring models.
Initial Impact of Applying for a Loan
When an individual applies for a personal loan, lenders typically conduct a “hard inquiry” on their credit report. This occurs because the lender needs to assess the applicant’s creditworthiness before extending new credit. The process involves requesting a full view of the applicant’s credit history from credit bureaus.
A hard inquiry results in a small, temporary dip in a credit score, usually by fewer than five points. These inquiries remain on a credit report for up to two years, but their negative effect on the credit score diminishes after about 12 months. This minor and short-lived impact is a standard part of applying for new credit.
It is important to distinguish hard inquiries from “soft inquiries.” A soft inquiry, such as checking one’s own credit score, receiving pre-approved offers, or background checks for employment, does not affect a credit score. Lenders may use soft inquiries for initial pre-qualifications. The impact of a hard inquiry is specifically tied to a formal application for new credit.
Ongoing Influence of an Active Personal Loan
Once a personal loan is approved and active, its presence on a credit report begins to influence various credit score components. One factor is the “new credit” element, which considers the average age of a borrower’s accounts. Opening a new loan account can slightly reduce this average age, leading to a minor, temporary adjustment in the credit score. This effect lessens as the new account ages on the credit report.
The “amounts owed” or “credit utilization” factor is also affected, although differently than with revolving credit like credit cards. A personal loan is an installment loan. While the total loan amount adds to a borrower’s overall debt, installment loans do not directly contribute to the credit utilization ratio in the same way revolving credit does. The full loan amount is initially reported, and the balance gradually decreases with each payment.
Another component influenced by an active personal loan is the “credit mix.” This factor assesses the diversity of credit types on a borrower’s report, including both revolving accounts (like credit cards) and installment accounts (like personal loans, mortgages, or auto loans). Adding an installment loan can positively diversify a credit profile, especially if the borrower previously held only revolving credit. A well-balanced credit mix demonstrates the ability to manage different types of debt responsibly, which can contribute to a stronger credit score.
Leveraging a Personal Loan for Credit Improvement
Responsible management of a personal loan can significantly contribute to credit improvement over time. The most impactful factor in credit scoring models, such as FICO and VantageScore, is payment history, accounting for 35% to 40% of a score. Consistently making on-time, full payments on a personal loan establishes a positive payment record, which helps build and maintain a strong credit score. Each timely payment demonstrates creditworthiness and financial discipline.
As payments are made on the personal loan, the outstanding balance decreases. This reduction in the “amounts owed” can positively influence the credit score, particularly if it contributes to lowering overall debt levels. For instance, if a personal loan is used for debt consolidation, paying down revolving credit balances with the loan can improve the credit utilization ratio, indirectly boosting the score.
Successfully paying off the personal loan further enhances the credit profile by demonstrating the ability to manage and complete a loan obligation. This positive completion contributes to the “length of credit history” and overall credit age, which are also considered in scoring models. Over time, a well-managed personal loan reinforces a positive credit history and supports future financial endeavors.