Does Taking Out a Personal Loan Hurt Your Credit?

Many individuals consider personal loans for various financial needs, from consolidating debt to financing large purchases. A personal loan is typically an unsecured installment loan, meaning it does not require collateral and involves fixed monthly payments over a set period. A common concern for potential borrowers is how taking on new debt might influence their credit standing. This article explores how a personal loan affects a credit score, as its impact can depend on several factors.

Understanding Credit Score Components

A credit score, such as a FICO Score, is a numerical representation of an individual’s creditworthiness, used by lenders to assess risk. This score is calculated using information from credit reports, with five main categories contributing to its determination:

Payment history (35%): Reflects the consistency of on-time payments across various accounts.
Amounts owed (30%): Indicates how much credit is currently utilized relative to available limits.
Length of credit history (15%): Benefits from older accounts and a longer overall credit timeline.
New credit (10%): Includes recent applications and newly opened accounts.
Credit mix (10%): The diversity of credit types, like revolving and installment accounts, demonstrating the ability to manage different forms of debt responsibly.

Initial Credit Score Impact

Applying for a personal loan typically initiates a hard inquiry on a credit report. This occurs when a lender checks credit history to evaluate risk. This hard inquiry can cause a small, temporary dip in a credit score, usually by fewer than five points. While a hard inquiry remains on a credit report for up to two years, its impact generally diminishes after a few months.

Upon approval and the opening of a new personal loan account, the average age of all credit accounts on a report may slightly decrease. This can have a minor, temporary negative effect on the credit score, especially for individuals with limited credit history. Additionally, the initial loan amount adds to the borrower’s total outstanding debt, which can temporarily increase the “amounts owed” factor and potentially lower the score at the outset.

How Personal Loan Repayment Affects Your Score

Consistent, on-time payments on a personal loan are a significant factor for improving credit scores over time. Since payment history constitutes the largest portion of a credit score, each timely payment reported to credit bureaus builds a positive record. This consistent adherence to payment schedules reinforces the borrower’s reliability and can counteract any initial negative impacts on the score.

As the principal balance of the installment loan decreases with each payment, the “amounts owed” component of the credit score improves. Unlike revolving credit, where balances can fluctuate, installment loan balances reduce predictably. This positively influences this factor over the loan’s term, leading to a gradual increase in the credit score as the loan progresses towards repayment.

A personal loan can also enhance a credit profile by diversifying the types of credit an individual manages. Having a mix of different credit types, such as revolving credit (like credit cards) and installment credit (like personal loans), is viewed favorably by credit scoring models. This demonstrates the ability to handle various financial obligations responsibly, potentially boosting the credit mix component of the score. Maintaining the account through regular payments until it is fully paid off contributes positively to the overall length of one’s credit history.

Strategies for Positive Credit Outcomes

To ensure a personal loan positively influences a credit score, making all payments on time is paramount. Setting up automatic payments can help prevent missed due dates, which are detrimental to payment history, the most impactful credit score factor. Consistent on-time payments are the most effective way to build a strong credit profile over the loan term.

Borrowers should also keep balances low on other credit accounts, particularly credit cards, to effectively manage the “amounts owed” factor. High credit utilization on revolving accounts can negatively affect scores, so maintaining low balances while repaying the personal loan helps to optimize this component. Borrowers should consider avoiding applications for excessive new credit during the personal loan repayment period, as multiple hard inquiries and new accounts can temporarily impact scores.

Regularly checking credit reports is a prudent strategy to monitor progress and identify any potential errors that could affect the score. Free annual credit reports are available from the three major credit bureaus. Finally, borrowing only the necessary amount for a personal loan helps ensure manageable monthly payments and prevents taking on more debt than can be comfortably repaid, which is crucial for responsible debt management.