Regardless of circumstance, there’s a chance you might need to borrow money in the future. And it could come from taking out a personal loan.
A personal loan can be used for anything—that’s why it’s personal. Having cash on hand to handle a financial emergency can be a lifesaver, but a personal loan can affect your credit score in both good and bad ways.
Personal Loans and Your Credit Score
Your credit score might fluctuate throughout your personal loan experience. It may rise and fall a few different times, including when you:
- Apply for the loan
- Take on personal loan debt
- Repay personal loan debt
Most personal loans are unsecured, which means lenders use your credit score to determine how responsible you are with credit. But after you’re approved for a loan, your credit score may go up or down—and sometimes both.
Applying for the Loan
Before a personal loan affects your credit score, your credit score affects your personal loan.
When you have a higher your credit score, lenders consider you likely to be irresponsible with credit, so you may qualify for better terms. On the other end, the lower your credit score, the less likely you are to be seen as creditworthy and approved for a low-interest personal loan.
A hard credit check is done when you apply for a personal loan. A hard credit check occurs when you give permission for a company—like a personal loan lender—to check your credit. Soft credit checks, like when you check your own credit score, don’t affect your credit.
When lenders trigger a hard inquiry, your credit score will take a temporary dip. Along with that, hard checks stay on your credit report for two years, although their importance lessens with time.
Hard credit checks have a relatively low impact on your total credit score—about 10%—but it also depends on your specific credit profile. If you don’t have a long credit history or many accounts, the hard credit inquiry could ding your score more.
Taking on Personal Loan Debt
If you’re looking to take out a personal loan to build your credit, keep in mind how it affects your score.
When you take out a personal loan, you’re increasing your credit mix, which makes up about 10% of your credit score and could give your credit score a boost. While increasing your credit mix is good, you’re also increasing the amount of debt you owe, which can cause your score to drop.
Aside from the principal amount you borrow, you’ll also be responsible for interest and fees, if the lender you choose charges any. Even if you have every intention of repaying your personal loan, it still means you’re increasing your debt burden. Even if you use your personal loan to take control of your existing debt—like paying off high-interest credit cards—you’ll need to adjust your spending to include that monthly loan payment.
Taking out a personal loan to build your credit isn’t a bad thing—as long as you can afford it. If you can’t afford it, you risk missing payments, which could lower your score. If you’re making your monthly payments, make sure lenders are reporting your payment history to the three major credit bureaus.
Lenders aren’t required to report your payment history. If yours doesn’t do so, you won’t have anything to show for your hard work when you start paying it off.
Repaying Personal Loan Debt
You’ll need to make sure you have enough money to repay your loan. If you qualified for a personal loan with low credit, you might face a higher interest rate when paying it back. Without room in your budget to account for a personal loan, you could fall behind on payments. Your payment history is the biggest factor in your credit score—it makes up 35% of your score. Missed personal loan payments can cause your credit score to plummet.
Going long enough with missed payments means your loan can go into default and eventually into collections. Negative information like defaulted loans can stay on your credit report for seven years. This may make it harder for you to qualify for borrowing money in the future, whether it’s a car loan, mortgage, or credit card. While the impact of your default lessens over time, it can still hurt your chances of taking out credit in the future.
If you’re diligent about making the minimum payment every month—or even paying off your loan early—your positive payment history will reflect that. Your credit score could take a jump thanks to on-time payments, especially over many months or years.
The Bottom Line
While a personal loan can help cover you in a financial bind, it can also affect your credit score as well. Before you apply for your loan, check your credit and clean up any errors. Improving your credit score and report before applying increases your chances of approval and may help you secure the lowest interest rate available.
When reviewing repayment terms, make sure you select terms that aren’t going to put stress on your budget. You might need to get longer terms with lower monthly payments to make sure you pay your loan back on time. If you can’t fit it into your budget and make timely payments every month, your credit score will take a dive.
Keep your credit score up by applying the following financial tips:
- Pay your monthly loan bill on time: Create room in your budget to account for your new bill, and don’t skip payments.
- Limit your credit card usage: If you’re using a personal loan to pay off high-interest debt, like a credit card, limit your use of that credit card while you do so. Otherwise, you’ll never pay off the credit debt, and you’ll just be adding more debt—that personal loan—to your plate. Your credit score won’t jump if your credit utilization stays high.
- Avoid lots of unnecessary credit: If you apply for many different types of credit, lenders may think you’re a risky borrower. Instead, only apply for new credit when you need it and when it makes financial sense—not necessarily when you want it.