How personal loans affect your credit score
Whether a surprise expense catches you off guard or you’re struggling to manage high-interest debt, a personal loan could help. These fixed-rate loans offer a lump sum of cash upfront, which you’ll repay — plus interest — over a set number of years. But before applying for a personal loan, understand how doing so could help or hurt your credit.
Ways a personal loan can help your credit
As long as you have a plan to pay it back, a personal loan could help improve your credit score. Here are some examples of how.
Building your payment history
When you take out a personal loan, you agree to make monthly payments of principal and interest until the loan is paid off. Making these payments on time can help you build a positive payment history, demonstrating to creditors that you’re able to repay your debt.
Since payment history impacts your credit score more than any other factor, staying on top of your personal loan payments can increase your credit score.
Improving your credit mix
Your credit mix consists of the different types of credit you have, such as revolving and installment accounts. Revolving accounts include any credit cards or lines of credit you have, while installment accounts consist of your mortgage, auto loans, student loans, and personal loans. Generally, having multiple types of credit is better.
For example, if your credit mix consists of a few credit cards and a home equity line of credit (HELOC), taking out a personal loan could add to your credit mix for a positive impact on your score.
Lowering your credit utilization ratio
Your credit utilization ratio is the amount you owe compared to your total available credit. If you have high-interest credit card debt, taking out a debt consolidation loan loan to pay it off could help save you money on interest and might even simplify repayment by rolling multiple payments into one.
Once that credit debt is paid in full, your credit utilization ratio should decrease. This helps your credit score by showing lenders you’re not relying on all of the credit available to you.
Ways a personal loan can hurt your credit
Personal loans don’t only help your credit, they also have the potential to hurt your score. So before taking out a loan, understand the ways in which a loan might have a negative impact, as well.
Missing payments
Just like making on-time payments can improve your credit over time, the opposite is also true: Missing payments can have a serious negative impact on your score. Lenders want to see that you’re consistently making all your payments on time — this gives them confidence you’re likely to pay them back, too.
Additionally, if taking on a personal loan increases your debt to the point where you struggle to pay other bills, your credit may suffer.
Initiating a hard credit inquiry
In general, any time you apply for new credit, the lender puts a hard inquiry on your account. This temporarily lowers your score by a few points. While the impact of new credit is relatively low, multiple inquiries within a short period of time can have a larger negative effect on your score. Typically, new credit inquiries remain on your credit report for two years.
Find out: Does opening a new credit card hurt your credit score?
Lowering your credit age
In general, the older your credit, the better. That’s because lenders like to see a consistent track record of you successfully managing debt. They calculate this risk by measuring your credit age, or the average amount of time your credit accounts have been open.
For instance, let’s say you have the following credit accounts and corresponding ages:
- Credit card A: 10 years
- Credit card B: 8 years
- Car loan: 3 years
In this case, your average credit age would be 7 years. We get this by dividing the total years by the total number of open accounts. But if you applied for a new loan (age = 0), your average credit age would drop to 5.25 years (dividing the total years of all accounts by four).
When you apply for a personal loan, you add a new account to your credit history and lower your average credit age, potentially docking your score by a few points.
Reducing your credit mix
While paying off a personal loan is a milestone you should be proud of, your credit score might not immediately reflect your accomplishment. In fact, paying off a loan can reduce your credit mix, temporarily lowering your score. Plus, if the loan you pay off is one of your older credit accounts, paying it off could shorten your credit age and have even more of a negative impact on your credit score.
That doesn’t mean you shouldn’t pay off your debt, by any means. Just make sure you do your due diligence before closing any accounts.
Using a personal loan to help your credit score
Taking out a personal loan can be a smart financial move if you need to cover an emergency expense or consolidate credit card debt. If you find yourself in one of these situations, use the following guidelines to avoid taking any major hits to your credit:
- Only borrow what you need. Anytime you borrow money, you risk hurting your credit if you can’t pay it back. Minimize this risk by only borrowing what you need (or not borrowing at all if you don’t need to). A smaller loan means lower monthly payments and a faster repayment timeline.
- Make on-time payments. Payment history is the biggest influence on your credit score, so do everything you can to pay on time. Put due dates in your calendar as a reminder, and if possible, enroll in autopay. Just keep an eye on your checking account to ensure you have enough cash to cover your payment.
- Don’t take out multiple loans at once. Taking out multiple loans means more debt and more payments to juggle — and potentially miss. Applying for several loans also means multiple new credit inquiries, which can lower your credit score. Protect your budget and your credit score by taking out only one loan at a time.
- Keep credit card accounts open. You might use a personal loan to consolidate and pay off credit card debt, which can ease some financial stress. But don’t make the mistake of closing those paid-off accounts. Doing so can lower your average credit age and reduce your available credit which increases your credit utilization ratio.
- Compare lenders before borrowing. When you take out a personal loan, don’t simply go with the first lender you see. Compare lenders to find the lowest interest rates and fees to minimize the cost of borrowing.
How long does a personal loan stay on your credit report?
Personal loans and other credit accounts generally stay on your credit report for up to seven years, though closed accounts in good standing might stay on your report even longer. This means that a personal loan could show up on your credit report even after you’ve paid it off.
Personal loan vs. credit card: Which is better?
If you need to borrow money, personal loans and credit cards can both do the job. Each has unique features and serves a slightly different purpose, so the better choice depends on your circumstances.
Here’s a quick overview of using a personal loan vs. credit card to help you decide between the two:
| Personal loan | Credit card | |
|---|---|---|
| Account type | Installment | Revolving |
| Fixed or variable interest? | Typically fixed | Typically variable |
| Average interest rate | ~12% (for a 2-year term)* | ~21%* |
| Fees | Origination fees, late fees | Annual fees, balance transfer fees, cash advance fees, foreign transaction fees, late payment fees |
| Repayment term | Usually 2 to 7 years | No fixed end date |
| Rewards | None | Cash back, points, miles |
| Best for | Large, unexpected purchases and debt consolidation | Daily spending |
*Source: The Federal Reserve
Frequently asked questions
Getting a personal loan involves a hard credit inquiry, which usually lowers your credit score by a few points. However, this dip is temporary, and making on-time payments can help improve your score over time. Whether or not your score takes more of a hit depends on other factors. For example, if you miss payments or dramatically lower your credit age, your credit score could drop further.
A personal loan has the potential to increase your credit score, but the extent to which your score increases depends on your specific situation. This includes your payment history, your credit utilization, your credit mix, and other factors.
There’s no universal credit score needed to get a personal loan, but individual lenders often require a score of at least 580 — meaning you’ll need fair credit to qualify. However, there are exceptions. Some lenders, such as Upstart, don’t have formal minimum credit score requirements.
