Personal loans can either help or hurt your credit, depending on a variety of factors. A personal loan can help you build credit in the long run if you manage your debt responsibly, and can even lower your credit utilization ratio, in the case of debt consolidation.
But things like a new inquiry on your report — or, more crucially, things like missed payments — can bring your score down. Knowing how a personal loan impacts your score can help you determine if one is right for you.
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How a personal loan can help your credit score
Payment history
Making each monthly loan payment by the due date adds to the number of timely payments on your credit report. Since your payment history makes up 35% of your FICO score, those on-time payments can help raise your credit score steadily over time. Additionally, it can show lenders that you're a responsible borrower and could make it easier for you to get credit in the future.
Set up automatic payments to avoid missing due dates. Some banks and online lenders also offer small APR discounts for setting up automatic payments.
Credit utilization
Your credit utilization ratio shows how much of your available credit you're using on revolving debt, such as credit cards. The ratio factors into your amounts owed, which makes up 30% of your credit score. While debt from personal loans doesn't factor into credit utilization, using a personal loan for debt consolidation can have an indirect effect. The utilization ratio on any cards you pay off completely would drop to 0%, likely providing a boost to your credit score.
Credit utilization is measured both on individual accounts, such as each credit card, and as an aggregate of all your revolving debt. FICO recommends keeping your total credit utilization ratio below 10%.
Credit mix
Lenders generally like to see that you know how to handle several types of credit and loan accounts. As such, 10% of your credit score is based on your credit mix. If you don't have an installment loan, such as a personal loan or auto loan in your credit history, adding one might provide a slight boost to your credit score. Making timely monthly payments on the loan could help even more.
How a personal loan can hurt your credit score
- Increases your debt: Taking on debt can bring down your score since, again, it would increase your total amount owed. This can affect your debt-to-income ratio (DTI), which lenders also use to determine whether to lend to you. Your DTI is the amount you pay monthly toward your debt, divided by your pretax monthly income. In general, it's best to have a DTI below 35%.
- Adds a new credit inquiry: When you send in an application for a personal loan, it triggers a hard credit inquiry, which is added to your credit profile. While this will typically have only a small impact on your credit, the number of inquiries over the last 12 months is also counted. In general, you want this number to be as small as possible. Inquiries typically stay on your credit report for two years.
"It's also critical to know you'll be able to make payments before taking out a personal loan. Your score can easily deteriorate if you find you can't make those payments on time or you begin to lag behind," said Christian Simmons, a certified educator in personal finance. "A credit score can seem like an abstract or unimportant concept to some people, but having a good one can put you ahead in a number of financial situations — while having a poor one can significantly set you back."
What credit score is needed for a personal loan?
Lenders generally want to see that you can meet certain requirements, such as a certain minimum credit score, to approve your application.
Lenders typically want to see a "good" FICO score of 670 or higher, though minimums among lenders vary.
Here's how FICO breaks down credit score ranges:
- Under 580: Poor
- 580 to 669: Fair
- 670 to 739: Good
- 740 to 799: Very Good
- 800 or higher: Exceptional
How to get a personal loan
Here are the steps to take out a personal loan:
- Determine your loan needs: You'll first need to know exactly how much you need to borrow and how you plan to use it. You should also know the features you require from a lender, such as online payments and discount opportunities.
- Gather documentation: Typically, you'll need to provide documentation such as pay stubs or bank statements, as well as proof of residence (like a utility bill) and a form of ID. Having those ready will streamline the application process.
- Shop around: You can start comparing lenders that meet your criteria. Consider factors such as loan amounts, time to fund, and repayment terms.
- Get prequalified: Prequalification checks to see if you're likely to qualify with a given lender, and if so, what your terms might look like — without hurting your credit. You should keep in mind, however, that prequalification does not show the exact rates or terms you'd receive if you formally applied to the loan. So there's some room for error, though it's still a helpful tool.
- Pick a lender: Consider the potential costs associated with each lender, such as the annual percentage rate (APR), which includes the interest rate and fees. But you should also check if the lender provides any of those extra features you pinpointed in your wish list. A loan calculator can come in handy here, since it can compare the potential costs associated with each lender.
- Send in your application: Follow the instructions supplied by the lender, including supplying any additional materials it may request. At this point, the lender will conduct a hard credit inquiry, which can lower your score slightly for about a year. The amount of time it will take to complete the application and get approved depends on the lender. Some lenders can fund your loan as soon as the same or next business day.
- Sign for the loan: Once approved, you can sign your loan documents, get your funds, and start making payments.
Learn More: How To Get a Personal Loan
How to improve your credit score after getting a personal loan
Once you've received your loan, your work as a responsible credit user isn't done. Here are a few strategies that could help boost your credit score:
- Repay your loan on time: Though a single on-time payment likely won't improve your credit score, making consistent on-time payments could make a big difference. Remember, payment history is the single largest factor in your FICO score, accounting for 35%.
- Consolidate debt, but don't eliminate cards: If you're using a debt consolidation loan to pay off credit cards, keep the cards open. The length of your credit history, which includes how long individual accounts have been open, accounts for 15% of your FICO score. Even though you may have resolved never to run up balances on those cards again, closing them would reduce the average age of your credit accounts.
- Wait before applying for new credit: Credit applications typically involve a hard credit inquiry that could lower your credit score by up to five points for as long as one year — and stay on your credit report for two years. So if the loan you just received triggered a hard credit check, your credit score may already be feeling the effects. Even a small, temporary dip in your credit score can chip away at any improvements you make.
- Keep an eye on your credit: Keeping tabs on your credit score can help you catch errors or unauthorized accounts that pop up. You can check your credit report for free with AnnualCreditReport.com or find out if your bank provides free credit monitoring.
FAQ
Can I take out a personal loan with bad credit?
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How does paying off a personal loan early affect my credit score?
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When should I take out a personal loan?
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Read More:
- What Are the Requirements for a Personal Loan?
- What Are Personal Loans Used For?
- Secured vs. Unsecured Personal Loans
- Best Personal Loans
- Best Personal Loans for Fair Credit
- Best Personal Loans for Good Credit
- Best Personal Loans for Excellent Credit
