How Personal Loans Affect Your Credit Score
Point of Interest
Personal loans can have negative short-term effects on your credit score, but positive long-term effects when used correctly.
A personal loan is a financial borrowing tool that can help when you need fast cash for just about anything. Popular uses include things like home improvements, paying medical bills, covering the cost of surprise expenses or bridging a financial gap. If you’re planning additional financial moves in the future, you may be concerned about what effect taking out a personal loan will have on your credit score. Understanding both the short term effects and long-term implications can help you to navigate the process much more efficiently and confidently.
How does a personal loan help your credit score?
Overall, the effects of a personal loan on your credit score will be positive, as long as you uphold your end of the borrowing agreement. Make good on your arrangement, and you should see a bump in your score. The best part? A personal loan affects several of the major factors that go into making up your credit score.
Reporting on-time payments
Your credit score is a reflection of your past borrowing habits, specifically your on-time or late payments. According to FICO, 35% of your credit score is based on your payment history. When you make on-time payments on your personal loan, you build a positive pattern of borrowing behavior. The result? Your credit score goes up.
Extending credit history
Another one of the five factors that go into your credit score is your length of credit history, which accounts for 15% of your score. The credit bureaus see less risk with lenders that have a long history of good borrowing habits. When you take out a personal loan, you add to the length of your borrowing history. The longer your history gets, the more of a positive impact it will have on this area of your credit score.
Multiple credit lines open
Credit mix refers to having varying types of debt and makes up 10% of your FICO credit score. In the reporting bureaus eyes, different types of loans should be viewed differently. For example, credit card debt is different than a mortgage loan because credit cards use revolving credit, whereas a mortgage loan is a fixed debt. The reporting bureaus like to see a healthy mix of the different types of available credit.
Depending on the makeup of your current debt profile, adding in a personal loan may help to expand your credit mix and raise your overall credit score. If you already have a good mix of credit, you may not see much of a change at all.
How does a personal loan hurt your credit score?
While a personal loan will have a long-term positive effect on your credit score, it may temporarily lower your score. This may not be ideal, but it makes sense. Remember, your credit score is a reflection of the risk you present to a lender. Taking out more debt increases the lender’s risk, regardless of whether you have a good or bad credit score. Additionally, there are risks to your credit score if you don’t follow through on your obligations to repay the loan.
Hard credit pull
During the application process, lenders need to look at your credit score to determine approval and what interest rates the company can offer you. This process generally involves a soft credit pull and a hard credit pull. The soft credit pull is done during the preapproval phase. When you fill out the quick form online that gets you a rate in a few minutes, this is what is being done. A soft pull has no impact on your credit score.
Once you decide on a lender and fill out the full application, you’ll undergo a hard credit pull. Think of the soft inquiry as a quick peek at your credit report and the hard inquiry as a detailed look at your records. The detailed look gives the lender the ability to extend an actual offer to you that you can accept.
The hard inquiry will have a lowering effect on your credit score. The good news is the lowering will be temporary, and it won’t be present on your account for the first 30 days. Additionally, after the first 30 days, most inquiries that occur during the same 45 day period will only count as one hard inquiry. Don’t let this be a deterrent from applying for a loan. The effects are felt by every borrower, and the effects are temporary.
Defaulting on payments
One of the worst things you can do to your credit score is making late payments or stop making payments altogether. Defaulting on your loan can have detrimental effects on your credit score for years to come. A single late payment can stay on your credit report and affect your score for up to seven years.
Whereas a hard pull on your credit has a small and temporary effect on your credit score, defaulting on payments can have a major and lasting effect on your score for years.
High debt-to-income ratio
If you’ve ever bought a house or researched the process, you’ve probably heard about the debt to income ratio. It’s a ratio that lenders look at to compare how much money you make with how much debt you are carrying. If the number is too high, you won’t get approval for your mortgage. It’s an additional metric that can be used to assess risk.
When you take out a personal loan, your debt to income ratio will go up. Now, this may not be a big deal if you’re not looking to borrow any more money anytime soon. But the increase in debt will affect your credit score. The second-largest contributing factor to your FICO credit score is the amount you owe.
Even if this is offset by an increase in income, it will still affect your credit score. The FICO score (the score used in over 90% of lending decisions) does not look at your income. Lenders will look at how much you make, but the effects will be felt in your credit score regardless.