Do Personal Loans Hurt Your Credit?: 6 Factors To Consider
Posted On June 29, 2022 · Length of read: 4 minutes
Personal loans allow you to cover unexpected costs, household renovations or other major life expenses without going into credit card debt. However, personal loans are still a form of debt, so you may wonder: do personal loans impact your credit score? After all, if a loan will tank your credit score just as much as high credit card debt does, what’s the point?
We’ll provide the information you need to understand whether a personal loan may negatively or positively impact your credit score.
What Is a Personal Loan?
Personal loans are available through banks, credit unions and online lenders, and they are a way to finance large purchases or refinance high-interest debt. Unlike student loans and mortgages, personal loans do not limit the use of an offered loan to a specific, pre-identified use case (unless otherwise stipulated by the lender). For instance, if you took out a loan to finance a new roof but have money left, you can spend the cash on whatever you choose.
Personal loans are typically between $1,000 and $100,000 and are paid back in monthly installments over the loan term (often 1 to 7 years), plus interest (4.99%-35.97%). The lender will determine the repayment term and interest rate on your personal loan based on your credit score, credit history, income and debt-to-income ratio among other things (i.e., your creditworthiness).
How Does a Personal Loan Impact Your Credit Score?
At its most basic, a credit score indicates how likely you are to fulfill recurring payments, such as personal loans, credit cards, or rent. Often ranging from 300 to 850, a credit score helps a lender decide whether to approve your loan application and determines the interest rate and repayment term you receive. An excellent credit score may get you a lower interest rate or longer repayment term (or both), and a poor credit score may get you the opposite.
But, the relationship between your credit score and personal loans does not end with how your credit score impacts your loan — the association also works in the other direction, with the application for and subsequent receipt of a personal loan affecting your credit score.
Specifically, applying for and receiving a personal loan may impact your credit score in the following six ways:
- Hard credit inquiries
- Volume of outstanding debt
- Credit utilization
- Credit mix
- On-time payment history
- Length of credit history
The following sections detail each factor so you can answer your question: do personal loans hurt your credit?
1. Hard Credit Inquiry
A lender runs what is known as a “hard inquiry” (or a credit check) to verify your creditworthiness, which may negatively impact your credit score for up to two years. However, the extent of the effect of a hard inquiry on your credit depends on your personal financial situation. For instance, if you have no other recent inquiries to your credit report, your score may only take a hit for a few months.
Tip: Try to submit all loan applications within 14 days to contain the impact. You may also want to “prequalify” with a lender to see what rates and terms you may receive — this is considered a “soft inquiry” and will not impact your credit score.
2. May Put You Further In Debt
Unless you intend to use a personal loan to consolidate debt, the fact is that taking out a loan means taking on debt — which goes on your credit report as a new credit account, potentially hurting your credit score.
Further, although your debt-to-income ratio does not impact your credit score, it does affect your ability to obtain credit. Why? Because a personal loan is a debt that may increase your debt-to-income ratio. If the loan pushes your ratio over 43%, future lenders may view you as high risk.
3. Improved Credit Utilization Ratio
Your credit utilization ratio is the sum of your outstanding debt divided by available credit. For example, if you have a total spending limit of $7,500 on your credit card and an outstanding balance of $750, you have a credit utilization of 10%.
But personal loans are installment credit (i.e., received as a lump sum and re-paid monthly) versus revolving credit (i.e., available credit used only as needed, repaid, then available for use again)… so what does this have to do with personal loans?
Well, suppose you use a personal loan to pay off credit card debt (or any other revolving credit). Then, you may reduce your outstanding revolving debt, thus reducing your credit utilization ratio, potentially leading to an improved credit score.
4. Diversify Your Credit Mix
One of the main determinants of your credit score is your “credit mix,” or the diversity of your debt portfolio. The different types of credit that credit bureaus include when calculating your credit mix are installment credit (e.g., student loans, personal loans, mortgages, and car loans) and revolving credit (e.g., credit cards and home equity lines of credit).
So if, for instance, you only have credit cards (a revolving loan), taking out a personal loan (an installment loan) will improve your credit mix and, thus, may lead to an increase in your credit score.
The reason for the emphasis on the credit mix? It shows lenders that you can manage multiple types of debt, especially if you fulfill your monthly payment obligations.
5. On-Time Payment Consistency
One of the biggest influences on your credit score is whether or not you consistently make your monthly personal loan payments on time. A steady stream of on-time payments (or positive credit history) will improve your score, while repeated late payments (or negative credit history) will harm your score.
As a result, a personal loan may allow you to improve a history of late payments by making on-time payments on your debt. But, missing payments on your personal loan may further lower your credit score.
6. Build Credit History
Credit history includes, among other factors:
- Historical management of existing or previous debt.
- Timeliness of payments.
- Number of credit lines.
- Age of your newest account.
- Age of your oldest account.
- Average age of all your accounts.
It is one of the components credit bureaus use to calculate your credit score and indicates to lenders that you have experience with debt.
Do Personal Loans Hurt Your Credit? Maybe. It’s Personal.
The answer to “does getting a personal loan hurt your credit?” can only be “it depends.”
However, if you limit credit applications, maintain a low level of debt and a mix of credit, and have a history of consistently making on-time, long-term payments, a personal loan may not only help you fund significant expenses or debt consolidation. It may also help you to improve your credit score.
The information provided in this blog post is not intended to provide legal, financial or tax advice. We recommend consulting with a financial adviser before making a major financial decision.