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Aside from getting an interest-free loan from a friend or relative, very few loan options rival a personal loan as a quick and easy source of funds. Personal loans are given as a lump sum, typically have lower rates than credit cards, and funding can be accessed within a few days — all without needing to put up your home or car as collateral. You can also use personal loans for almost any purpose, including medical expenses, home repairs, or credit card debt consolidation.

But what does taking out a personal loan do to your credit score? Introducing new credit in the form of a personal loan can have a positive effect on your credit profile, but it can also cause damage to your credit if not used properly. We’ll break down what you need to know about personal loans and your credit score.

How Personal Loans Can Help Your Credit Score

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It is common knowledge that on-time, consistent payments will help improve your credit score. Using these same principles, personal loans can be leveraged to boost one’s credit score if used wisely. 

Build Payment History

According to the Fair Isaac Corporation (FICO), payment history accounts for 35% of your credit score and is a big indicator of your creditworthiness and eligibility for other credit products. In addition, their research indicates that your payment patterns are the most accurate predictor of your potential to pay off all your debts.

So, making on-time payments on your personal loan can help you create a solid payment history that can contribute to a higher credit score. However, remember that a few late monthly payments won’t automatically damage your credit score, but it’s still recommended that you keep up with on-time payments to improve your credit. 

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Diversify Credit Mix

Your credit mix accounts for 10% of your FICO Score. Lenders like borrowers with various types of credit, such as installment loans, credit cards, auto loans, and mortgages. Having a diverse credit mix demonstrates that you can efficiently manage all types of debt, making you a lower risk to lenders.

Since a personal loan is a type of installment loan, adding one to your credit profile can diversify your credit mix, especially if your credit history only contains credit cards. 

Decrease Credit Utilization Ratio

Using a low-interest personal loan to pay off credit card debt can lower your credit utilization ratio, which measures how much revolving debt you have compared to your available credit. A higher credit utilization ratio means you are spending more and creating more debt, which makes you a riskier consumer to lenders.

Keeping your credit card balance down by paying off that debt through a debt consolidation loan is one way to free up your available credit and boost your trustworthiness to lenders.

How Personal Loans Can Hurt Your Credit Score

Whenever you take out a personal loan, you do receive credit-enhancing benefits. But there is the potential that your credit score could drop from taking out a personal loan.

Hard Credit Inquiries

When you apply for a personal loan, the lender will perform a hard inquiry to pull your credit report and history. A hard inquiry usually results in a temporary decrease in your credit score by several points in the short-term. But the good news is that the hard inquiry will eventually fall off and your credit score can rebound.

Also, be aware that taking out multiple loans simultaneously would result in multiple hard credit inquiries, which can have a larger negative effect on your credit score.

Late or Missed Payments

Arguably one of the most severe hazards of borrowing a large sum of money is assuming more debt than you can afford to pay back. Frequent late or missed payments can have a negative impact on your payment history and contribute to a lower credit score.

Before you apply for a personal loan, you should assess your budget to make sure you can make your payments on time for the entire loan period. 

Increase in Overall Debt Owed

Even if you are ready to assume more debt, adding a new personal loan balance can negatively impact your credit score by increasing your overall amount of debt owed, which makes up 30% of your FICO Score.

While owing more debt doesn’t necessarily mean you are a risky borrower, it can increase your debt-to-income ratio and make it harder to qualify for different types of loans, such as mortgages.

What Credit Score Is Needed for a Personal Loan?

Personal loan credit score requirements will vary depending on the lender. The average credit score to qualify for a personal loan is in the low to mid 600s. Some lenders may approve borrowers with a credit score as low as 300, but those loans will typically come with very high rates and unfavorable loan terms. The higher your credit score, the better your borrowing terms, such as lower rates and longer repayment periods.

You can prequalify for a personal loan to find the lowest rates across different lenders. Shopping around can help ensure that you find the best loan terms for you.

Tips to Improve Your Credit Score for a Personal Loan

Credit Karma app over credit score
Slickdeals/Credit Karma

Even if you are in the process of applying for a personal loan, you can take action to boost your credit score quickly in a short period. Start by checking your credit reports for free from the three major credit bureaus: Equifax, TransUnion, and Experian. 

Once you have reviewed your credit report, there are a few activities you can employ to improve your credit score quickly. 

  • Pay off debt. Pay off as much of your revolving credit as you can, especially if you have high-interest debt. Paying off credit card debt is one way to decrease your credit utilization ratio and improve your credit score.
  • Report any inaccuracies on your credit report. Contact your creditors to remove any inaccuracies or errors that may be damaging to your credit report. These errors could be accounts created due to identity theft, or incorrect account balances or credit limits. Correcting these can help improve your credit score.
  • Be an authorized user on a credit card. Another credit-lowering hack is persuading a friend or relative to add you as an authorized user to their account. As long as the account maintains a perfect payment history and low credit utilization, adding it to your credit report can help give a boost to your credit score.

Using a Personal Loan to Your Advantage

A personal loan can be a great credit-building opportunity if used properly, but be aware of the potential harm that it can have on your credit score. You may see your score go up and down during the initial personal loan application process, but as long as you keep up with payments and manage your debt wisely, you can leverage it as a way to boost your credit.

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FAQs

  • When processing your personal loan application, lenders do a hard credit check that causes a slight drop in your credit score. But the drop is usually temporary and recovers within a year.

  • Your personal loan adds diversity to your credit mix and is likely one of your older open credit accounts. When you pay off the loan, the account closes and is no longer a contributing factor to your credit mix or average account age. This can result in a drop in your credit score.

  • Borrowers with fair credit scores above 640 can usually qualify for low interest rates and attractive terms. Those with excellent credit scores of 750 and above can usually qualify for the lowest rates and the best terms.

  • Lenders generally supply the major credit reporting agencies with new information every 30 to 45 days. So, you can expect to see your personal loan account on your credit report within this time frame.

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