How Will a Personal Loan Affect Your Credit Score?
Learn how a personal loan application and its ongoing management can influence your credit score, from initial inquiry to long-term impact.
A personal loan is a lump sum repaid in fixed monthly installments over a set period. These loans are typically unsecured, meaning they do not require collateral such as a house or car. They offer a predictable repayment schedule, making budgeting simpler, and can be used for various purposes like debt consolidation or unexpected expenses.
A credit score is a numerical summary, typically from 300 to 850, of an individual’s creditworthiness. Lenders use this score to assess the likelihood of a borrower repaying debt, influencing decisions on loan approvals, interest rates, and other credit terms. A higher score generally indicates a lower risk to lenders and can lead to more favorable borrowing opportunities.
Immediate Effects on Your Credit
Applying for a personal loan initiates a hard inquiry on your credit report when a lender checks your credit history. A hard inquiry can cause a small, temporary dip in your credit score, usually by less than five points.
While a hard inquiry remains on your credit report for up to two years, its impact on your credit score generally diminishes after a few months and typically ceases to affect the score after one year. Multiple hard inquiries within a short timeframe can be viewed less favorably by lenders.
Upon approval, the new personal loan account appears on your credit report as an installment loan. Opening a new account can slightly reduce the average age of your overall credit accounts. Unlike revolving credit, the initial loan amount does not immediately impact credit utilization, as it is a fixed installment debt.
Ongoing Influence on Your Credit
The most significant factor influencing your credit score over time is your payment history. Consistently making on-time payments for your personal loan positively contributes to your credit profile. Each timely payment demonstrates responsible financial management, which is a strong indicator for future lenders.
Conversely, late payments, missed payments, or defaults can severely damage your credit score. Payments reported 30 days or more past their due date can have a substantial negative impact, and these negative marks can remain on your credit report for up to seven years. The severity of the damage increases with the lateness and frequency of missed payments.
Adding an installment loan to a credit profile primarily consisting of revolving credit can improve your credit mix. Credit scoring models view a diverse mix of accounts favorably, demonstrating an ability to manage different types of debt.
As you pay down your personal loan, your overall debt burden decreases. While personal loans do not have a credit utilization rate, the reduction of the reported loan balance as payments are made is a positive signal to credit scoring models. This shows a decreasing amount owed, which can be beneficial for your credit score.
How Personal Loans Relate to Credit Score Components
Personal loans interact with the various components that comprise a credit score, each weighted differently in common scoring models like FICO.
Payment history is the largest factor, accounting for approximately 35% of a FICO Score. Making consistent, on-time payments on a personal loan directly contributes to building a positive payment history, which is a strong indicator of financial reliability.
The “Amounts Owed” category makes up about 30% of a FICO Score. For personal loans, this component considers the outstanding balance compared to the original loan amount. As the loan is paid down, the percentage of the original loan amount still owed decreases, which can positively influence this category, indicating a reduced debt burden.
Length of credit history accounts for approximately 15% of a FICO Score. The age of the personal loan account, along with all other credit accounts, contributes to the overall average age of your credit history. A longer established history, demonstrating consistent management of accounts, generally benefits this component.
New credit, which includes hard inquiries and newly opened accounts, constitutes about 10% of a FICO Score. The hard inquiry generated when applying for a personal loan, and the subsequent opening of a new account, are factors considered within this category. While these can cause a minor, temporary score adjustment, their impact is typically short-lived.
Finally, credit mix accounts for about 10% of a FICO Score. Having a personal loan, which is an installment account, alongside revolving accounts like credit cards, can demonstrate an ability to manage different types of credit responsibly. This diversification can positively influence your credit score by showing a broader range of credit management experience.