How does a personal loan affect your credit score?

How can a personal loan help your credit score?

If you use your personal loan wisely, it can help improve your credit score. Your ability to make on-time payments, the diversity and age of your credit products and the amount of revolving credit you use are some of the most important credit score factors that a personal loan can influence.

Personal loans help you build a payment history

If you get a personal loan, be sure to make on-time payments in full each month. By doing this consistently for months or years, you can build a positive payment history and improve your credit score. Given that payment history makes up 35% of your FICO score, you can expect a noticeable increase in your credit score after you make consistent payments for a relatively short period of time.

Even just one year of repaying a personal loan can “... lead to a noticeable improvement in credit scores,” said Seth Jacobs, a manager of LeaderOne Financial Corporation’s branch in Brunswick, Maine. “On average, borrowers can anticipate their credit score to increase by around 40 to 60 points over the course of a year. Individual results can vary based on factors like the borrower's starting credit score and overall credit history.”

It’s a good idea to set up payment reminders a day or two in advance so you don’t ever miss a payment.

Personal loans help you diversify your credit mix

Personal loans are known as installment loans, meaning you pay your borrowed money back in equal installments over a fixed period of time. Some other examples of this type of loan are mortgages, student loans and car loans.

Revolving loans, on the other hand, provide a line of credit that is used and paid down repeatedly, like credit cards and home equity lines of credit (HELOCs). If you only have revolving debt, a personal loan could diversify your credit mix and improve your score.

Your credit mix makes up 10% of your FICO credit score. According to Nikita Sherbina, CEO of AIScreen, “Adding an installment credit product to a borrower’s credit mix can potentially lead to a credit score increase of around 20 to 50 points. This is due to the positive impact of diversifying the types of credit used, showcasing responsible financial behavior and demonstrating the ability to manage different types of debt effectively.”

Personal loans can lower your credit utilization ratio

Keep your credit utilization below 30% to improve or maintain your credit score.

Your credit utilization ratio measures how much of your available revolving credit you’re using out of your total revolving credit limit. The Consumer Financial Protection Bureau recommends keeping your credit usage below 30% to improve or maintain your credit score. That means if you have $10,000 in credit available to you, you should never have more than a $3,000 balance across all your revolving credit products collectively.

Your credit utilization is only impacted by revolving accounts like credit cards, personal lines of credit and HELOCs. Because a personal loan is an installment product, it isn’t directly factored into your credit utilization. However, you can use a personal loan to consolidate debts from revolving credit accounts, which can significantly reduce your credit utilization.

This is a win/win scenario, because having a lower credit utilization rate will improve your credit score, and the consolidation loan may have a much lower interest rate than your revolving credit accounts.

» MORE: How do personal loans work?

How can a personal loan hurt your credit score?

When you get a personal loan from a bank, credit union or online lender, it’s critical to know how the loan could negatively impact your credit score. This knowledge can help you avoid making credit-denting mistakes.

Personal loans run hard credit checks

When you apply for a personal loan, the lender does a credit check, which results in a hard inquiry. Hard inquiries can drop your score by 5 to 10 points or so, and they can affect your credit score for up to two years. The more hard inquiries you have, the greater the negative impact.

If you’re trying to find a lender that will give you the best terms, try to submit all your applications within the same 14-day window. Doing so increases your chances of credit-scoring companies like VantageScore counting your applications as one inquiry instead of multiple inquiries.

VantageScore counts multiple credit checks for the same type of loan as one check if they’re all done within a 14-day period.

Personal loans ding your credit for late payments

If you miss a payment by an entire billing cycle, you could lose anywhere from 60 to 130 points. Missed payments can also become a compounding problem if your lender is applying late fees each time.

If you do get behind, start making payments again as soon as possible to help your credit rebound. Your payment history information consists of:

• The total number of past-due items in your credit report
• How long your payments are or have been overdue
• The amount of time that has passed since your last delinquency

So, resuming payments immediately can help stop your credit score from hemorrhaging.

Personal loans can encourage bad spending habits

While personal loans can be a great way to consolidate your credit card debt, it’s important to change your spending habits if they’re what led you into debt in the first place.

You don’t want to take out a personal loan to avoid paying high interest rates on a credit card, only to find yourself spending outside your means again. If that happens, you’ll not only be paying back the personal loan, but you’ll also have more credit card debt.

Paying off a personal loan could ding your credit again

While it sounds counterintuitive, when you pay off your personal loan, you could see a temporary dip in your credit score. This happens if you reduce the average age or the diversity of your credit products. Don’t fret, though. With good spending habits, that dropped amount will rebound over time.

» MORE: How to get out of debt

Monitoring a personal loan’s credit impact

Checking your credit reports and scores can help you predict how likely you are to get approved for a personal loan, which can limit unnecessary hard inquiries. Also, the higher your score, the more likely you are to get a low interest rate.

If you’d like to avoid hard inquiries, getting preapproved for a personal loan can give you insight into whether you’re likely to qualify. Preapproval doesn’t guarantee approval. But because it’s typically a soft inquiry, it can help you avoid a hard inquiry if you end up not qualifying.

Once you’re approved for a personal loan and start making regular payments, you can monitor your credit to keep a pulse on how it’s doing. There are many ways to monitor your credit, but two of the most popular are:

1. Access your credit report for free at AnnualCreditReport.com. You’re entitled to a free credit report once a year from each credit reporting company.
2. Pay a company like FICO to track your credit score. Its plans also include identity theft protection, identity monitoring and credit reports.

» COMPARE: Best personal loan companies

Bottom line

A better credit score can unlock a lot of new opportunities in your life. It may allow you to get a higher credit limit, which could help you pay for something like a trip abroad. Good credit may also help you qualify for a mortgage and become a homeowner. Having good credit matters, which is why you should always use a personal loan wisely.