Taking out a personal loan can both help and hurt your credit. In the short term, applying for a new loan can have a small, negative impact on your scores, due to the hard inquiry by the lender. If managed well, however, having a personal loan can boost your credit profile over time by adding to your positive payment history and broadening your credit mix. This could make it easier to get approved for loans and credit cards with attractive rates and terms in the future.
Here’s a closer look at how personal loans affect your credit score, both positively and negatively, plus guidelines on when it makes sense to take one out.
Key Points
• Personal loans can initially take a few points off your credit score due to the lender’s hard inquiry.
• Responsible management of a personal loan can help build your credit by adding to your positive payment history.
• Missing payments on a personal loan can significantly harm your credit score.
• Personal loans can help lower credit utilization if used to pay off credit card debt.
• Over time, having a personal loan should benefit your credit more than harm it.
How Is Your Credit Score Calculated?
Understanding how personal loans impact your credit starts with knowing how your credit score is calculated. The most common credit scoring model, FICO®, uses five components to calculate your score. Here’s a look at each factor and how much weight it’s given in FICO’s calculation.
• Payment History (35%): Your record of making on-time payments to lenders is the most important component of your score. This helps creditors determine how much risk they are taking on by extending credit.
• Amounts Owed (30%): This includes the total amount of debt you currently have and your credit utilization ratio, which measures the percentage of available credit you’re using. If you’re tapping a lot of your available credit on your credit cards, it suggests you may be overextended and, thus, at higher risk of defaulting on a loan.
• Length of Credit History (15%): This factor takes into account the average age of your accounts, the age of your oldest account, and how long it has been since you used certain accounts. Generally, having a longer credit history can positively affect your score.
• New Credit (10%): A small but still important part of your score is how much new credit you’ve recently taken out. Opening new accounts or having too many credit inquiries can temporarily lower your score.
• Credit Mix (10%): Your credit mix looks at how many different types of credit you hold. Having a variety of credit types — like credit cards, retail accounts, and installment loans — can positively affect your score.
A personal loan can influence several of these factors, for better or worse, depending on how you manage it.
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How Do Personal Loans Work?
A personal loan is a lump sum of money borrowed from a lender, such as a bank, credit union, or online lender. Personal loans are typically unsecured, meaning you don’t need to provide collateral (like your car or home), and can be used for various purposes like consolidating debt, covering medical bills, or funding a wedding.
When you take out a personal loan, you agree to repay it in fixed monthly installments over a predetermined period, usually ranging from two to seven years. The interest rate, determined by your creditworthiness, and any lender fees affect how much you’ll pay in total.
Recommended: Is There a Minimum Credit Score for Getting a Personal Loan?
Ways Personal Loans Can Hurt Your Credit
While personal loans can be beneficial, they also have the potential to harm your credit. Here’s how:
Requires a Hard Credit Inquiry
When you apply for a personal loan, the lender typically performs a hard credit inquiry to evaluate your creditworthiness, which can adversely impact your credit score. Hard inquiries remain on your credit report for two years. However, their negative effect on your score is minor (typically 5 points or less) and lasts only about a year.
Note that prequalifying for a personal loan, which involves a soft inquiry, won’t have any impact on your score. This can give you an estimate of the interest rate and loan amount you can expect in a loan offer.
Can Increase Overall Debt
Taking out a personal loan can increase your overall debt, which can negatively affect the “amounts owed” component of your credit score. This may cause you to see a slight drop in your score. However, if you’re consolidating credit card debt, you will reduce that debt by paying it down with the personal loan, and your amounts owed won’t be impacted.
Can Negatively Impact Payment History If You Miss a Payment
Since payment history is the largest factor in credit scoring, missing just one payment on your personal loan can result in a substantial drop in your score. While being just a few days late may not affect your credit, lenders can report payments that are more than 30 days overdue to the credit bureaus. Late payments remain on your credit reports for seven years.
Setting up autopay or reminders can help ensure you make your payments on time and avoid this credit score setback.
Can Shorten Your Credit History
Taking on a new loan can shorten the average age of your credit accounts, which could have a small negative impact on your score. Generally, a longer credit history is considered better than a shorter one.
How Personal Loans Can Help Your Credit
Despite the risks, personal loans can also positively influence your credit when managed wisely. Here’s how:
Can Add to Your Credit Mix
Your credit mix accounts for 10% of your score. Adding a personal loan to your portfolio — especially if you primarily have revolving credit, like credit cards — can enhance your credit profile by showing that you can manage different types of credit responsibly.
Can Improve Your On-Time Payment History
Consistently making on-time payments on your personal loan demonstrates financial responsibility, which can strengthen your payment history — the most significant component of your score. It may take a few months for the benefits to show up but over time, this can positively impact your credit.
May Help Lower Your Credit Utilization Ratio
If you take out a personal loan to pay off high-interest credit card debt (also known as a credit card consolidation loan), you can lower your credit utilization ratio, which is the percentage of your available credit you’re using. A lower ratio — ideally under 30% — is generally beneficial for your credit. However, this strategy only works if you keep your credit card spending low after paying off your balances with the loan.
When to Consider Taking Out a Personal Loan
Even though applying for a personal loan may result in a small, temporary drop in your credit score, there are times when taking on this type of debt can be a smart financial move. Here are some scenarios where you might consider getting a personal loan.
• You want to consolidate high-interest debt: Personal loans typically have lower interest rates than credit cards, making them an attractive choice for paying off expensive credit card debt. An online personal loan calculator can help you determine how much you could potentially save. If you’re juggling several credit cards, a debt consolidation loan can also simplify repayment.
• You’re facing unexpected expenses: Medical bills, home and car repairs, or other emergencies can sometimes justify taking out a loan. Using a personal loan may be more cost effective than putting these expenses on your credit card.
• You have good or excellent credit: The best personal loan interest rates are generally reserved for borrowers who have strong credit. While there are personal loans for bad credit, they typically come with higher interest rates and other less-than-ideal terms.
• You earn a steady paycheck: Getting a personal loan generally only makes sense if you have a regular income and earn enough to comfortably cover the monthly payments for the term you select.
The Takeaway
Personal loans can have a positive or negative impact on your credit depending on how you manage them. Initially, applying for a personal loan can slightly downgrade your score. This is due to the hard inquiry, as well as the loan’s impact on the average age of your accounts and (potentially) your overall debt load. However, if you repay the loan responsibly, having a personal loan can ultimately help your credit by adding positive payment history, diversifying your credit mix, and — if you use it pay off credit card debt — reducing your credit utilization rate.
Before taking out a personal loan, you’ll want to assess your financial situation, shop around for the best rates and terms, and make sure the monthly payments work with your budget.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. See your rate in minutes.
FAQ
Is a personal loan bad for your credit?
A personal loan isn’t inherently bad for your credit, but its impact depends on how you manage it. Initially, applying for a loan may lower your score slightly due to the hard credit inquiry. In addition, taking on more debt can increase your amounts owed, which might affect your score. However, consistently making on-time payments can boost your payment history, a major factor in credit scores. And if you use a personal loan to consolidate credit card debt, you’ll lower your credit utilization ratio (how much of your credit limit you are using), which can positively impact your credit.
Will a personal loan affect my credit card application?
It can. If you applied for the loan recently, the hard credit inquiry may have slightly lowered your credit scores. Having a personal loan can also lower the average age of your accounts and, potentially, increase your debt load, which can negatively impact your credit. Over time, however, having a personal loan can improve your credit profile by adding to your positive payment history and, if you use it to consolidate credit card debt, lowering your credit utilization, making it easier to get approved for a credit card.
Will a personal loan affect my car loan application?
It can. When assessing your eligibility for a car loan, lenders typically consider your credit score, debt-to-income ratio, and overall financial profile. The hard credit inquiry for the personal loan might lower your credit score temporarily. In addition, the added debt from the loan could increase your debt-to-income ratio, making you appear higher risk to a lender. On the other hand, responsible repayment of the personal loan shows financial discipline, which can improve your credit profile over time. Ultimately, this could make it easier to get a car loan with attractive rates and terms.
About the author
Julia Califano
Julia Califano is an award-winning journalist who covers banking, small business, personal loans, student loans, and other money issues for SoFi. She has over 20 years of experience writing about personal finance and lifestyle topics. Read full bio.
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