How Does a Personal Loan Affect Your Credit Score?

For many people, taking out a personal loan can be a convenient way to consolidate credit card debt, pay off medical bills, or just get the money needed for big projects like home renovations. The question is: How will a personal loan affect your credit score?

With consistent on-time payments and proper management, taking out a personal loan can actually help boost your credit score over time. But, like any form of debt, improper management of a personal loan can negatively impact your credit score, too.

Before you make any big decisions, it’s important to understand the pros and cons of a personal loan and how it could help or hurt your credit score in the future. Let’s start with the basics.

What is a personal loan?

Personal loans are consumer loans that are taken out without a specific purpose. Unlike a mortgage or auto loan, personal loans can be used for most things, from paying off medical debt to renovating your bathroom — and everything in between.

Secured loans, such as mortgages and auto loans, require some form of collateral to acquire. This means that their interest rates are typically very low. Personal loans are sometimes unsecured, meaning they don’t require any kind of collateral, but that does mean that their interest rates can be higher.

That said, these kinds of loans still offer lower interest rates than many credit cards. For this reason, personal loans are often used for debt consolidation.

Personal loans can be acquired from a variety of lenders, most commonly banks and credit unions. Your credit score will determine your particular interest rate and how much you qualify to borrow.

Woman applying for a personal loan online

So, how can a personal loan hurt your credit score?

Taking out a personal loan — and sometimes even shopping around for rates on personal loans — can negatively impact your credit score in a variety of ways. Most of the items listed below can be avoided by simply making your monthly loan payments on time, but it’s important to know all the ways a personal loan could affect your credit score before you choose to borrow money.

Hard Inquiries

The first and least impactful way that a personal loan can affect your credit score happens when you apply for the loan itself. Any time you apply for credit, a lender needs to access your credit report to ensure you qualify. This is what’s known as a “hard inquiry” on your credit report. Once a hard inquiry occurs, your credit score will typically drop by a few points. The good news is that if you obtain a personal loan and make your monthly payments on time, your credit score should recover after a few months. Learn more about applying for personal loans here.

Missed or Late Payments

Missing a payment or making a late payment to your personal loan can have a serious negative impact on your credit score. In fact, making your monthly payments on time is the single biggest factor when it comes to your credit score health for both FICO and VantageScore, two common credit scoring models. While making a payment a few days late likely won’t have an impact, personal loan payments that are more than 30 days late could cause significant damage to your score — potentially over 100 points worth of damage.

It’s also important to note that taking on any new form of debt can throw off your typical monthly budget. While you might not miss a payment on your personal loan, the new strain on your finances could cause missed or late payments for other bills, which could impact your credit in much the same way. That’s why it’s important to create a detailed budget and ensure you can manage the new responsibility before you borrow.

Increased Debt-to-Income Ratio

If you’re considering taking out a personal loan for the purposes of debt consolidation, this might not apply to your situation. But for those who are planning to use a personal loan for things like remodeling their home or replacing a damaged roof, it’s important to recognize that the new credit will likely skew your debt-to-income ratio (DTI).

While your DTI doesn’t directly impact your credit score, taking on new debt does increase the amount you owe overall, and that can negatively impact your score. Having a higher DTI can also make it difficult to qualify for certain types of credit, including both mortgages and auto loans.

Can a personal loan improve your credit score?

A personal loan can absolutely improve your credit score — but only if you consistently make your monthly payments on time. First, personal loans can help you diversify your credit mix, which is one of the many factors in determining your overall credit score. For instance, if you only had credit cards in the past, adding a personal loan shows lenders that you’re capable of managing multiple types of credit — and that’s a good thing.

Personal loans also add another element to your payment history, and if you always make your payments on time, your credit score will go up. On top of that, personal loans may help reduce your overall credit utilization when used for credit card consolidation.

Maintaining high balances on your credit cards can negatively impact your credit score. When you take out a personal loan to pay off those cards, your overall “debt” increases, but your credit utilization drops dramatically. This can have a positive effect on your overall score.

Is a personal loan right for you?

That’s a question that only you can answer, but hopefully the information here can help. Taking out a personal loan can affect your credit score in both positive and negative ways, and it’s important to recognize those pros and cons before borrowing funds.

One of the best ways to decide if a personal loan is right for you is to create a detailed monthly budget that outlines all of your expenses and existing debts. Whether you’re planning to use the personal loan for debt consolidation or another expense, be sure the new monthly payment will work within your budget. After all, your ability to make on-time monthly payments will play a critical role when it comes to your credit score.