Getting a personal loan can be a great way to accomplish two goals at once: borrow money for a large purchase you need to make and build your credit score. This can help you in the future if you want to open a rewards credit card or borrow more money, such as a mortgage to buy a house.
One of the weird things about using personal loans to build credit is that it affects your credit score in many different ways, both good and bad. If you make all your payments on time, the net impact is usually positive. Still, it’s helpful to know the different ways that personal loans affect credit scores so that you’re not surprised if your score heads in a different direction than you were intending.
Factors That Determine Your Credit Score
Your credit score is based on the following factors, according to FICO, the most popular credit scoring company:
- Payment history—35%
- Amounts owed—30%
- Length of credit history—15%
- Credit mix—10%
- New credit—10%
Your personal loan will affect each of these factors in different ways and at different times. Let’s see how they work as you go through the lifecycle of a personal loan.
Shopping for a Personal Loan
In most cases, shopping around for a personal loan won’t affect your credit score. That’s because most lenders run a soft credit pull when you provide your information to see what rate you qualify for. This doesn’t get recorded as an official inquiry on your credit report—that won’t happen until the next step.
When you’re shopping around to check your rate before you apply for a loan, it’s always a good idea to confirm that the lender will do a soft credit pull—rather than a hard inquiry. Otherwise, you could be unfairly docked a few points on your credit score if they run a hard credit check instead.
Applying for a Personal Loan
Applying for a personal loan can lead to a five-point credit score drop for most people. That’s because when you’re ready to apply for the loan, the lender does a more detailed credit check, known as a hard credit pull. This actually does get recorded on your credit report as a credit inquiry, and because shopping for loans is a somewhat risky activity, your credit score usually goes down a few points accordingly.
The good news is that these credit inquiries only last a short period of time. After a year they’ll stop negatively affecting your credit score, and they’ll fall off your credit report entirely after two years.
Repaying Your Personal Loan
You’re most likely to see the biggest boost in your credit score as you make your payments on time every month. Payment history is the biggest factor in your credit score, after all, and with each passing month that you record an on-time payment, your credit score can slowly improve.
On the flip side, this is the time period when you’re most in danger of hurting your credit score, too. If you make a late payment your score can decrease, but how far it drops depends on a few things:
- Time overdue. Payments are reported late starting at 30 days, and then later the payment, the worse the effect on your score.
- Amount overdue. The more you’re past due in paying, the more negative the impact on your score.
- Frequency. The more often you make late payments, the worse the effect on your score. If all you have is one late payment, the effect might not be as bad.
As time passes, these late payments won’t keep your score down quite as much, especially if you make the rest of your payments on time. Late payments fall off of your credit report after seven years.
Why Does Paying Off a Loan Hurt Credit?
A smaller part of your credit score is made up of your credit mix—what types of credit you have, such as credit cards, mortgages, student loans and personal loans. Taking out a personal loan diversifies your credit mix, which helps your score. On the other hand, paying off your personal loan decreases your credit mix, especially if it’s the only type of instalment loan you have.
That’s why paying off your personal loan can sometimes decrease your credit score. Still, it’s a good thing to be out of debt.
Debt Consolidation
If you have a lot of unsecured debts such as credit cards or other personal loans, it can sometimes make sense to consolidate them by taking out one larger personal loan to pay off all of these other debts. This gives you a few advantages:
- You only make one payment instead of many
- You might be able to get a better interest rate
- You may be able to increase your credit score
Diversify Your Credit Mix
Consolidating your debt helps your credit score in two main ways. First, you might be able to diversify your credit mix if you don’t already have a personal loan. As long as you can manage them well, lenders like to see that you can handle multiple kinds of debt, and you’re rewarded for this with a better credit score.
Lower Your Credit Utilization Ratio
If you have credit card debt, an even bigger benefit of consolidating your debt is being able to lower your credit utilization ratio. This is the ratio between how much you owe and how high your credit limit is, combined across all of your credit cards. The rationale behind this is that the closer you are to maxing your cards out, the riskier you are, and so your credit score is docked accordingly.
By moving that debt from your credit card balance to a personal loan, you suddenly free up your credit card balance so it looks like you’re only using a tiny bit of your available credit. This makes you look more trustworthy to lenders, and so your credit score may go up as a result.
Of course, for this strategy to work, you need to keep those credit card balances down too. Just because you have a lot of available credit now doesn’t mean that it’s a good idea to charge up a high balance again. If you do, you’ll be right back where you started—but with more debt in the form of a personal loan.
Bottom Line
Watching how your personal loans affect your credit score is a bit like following a rollercoaster ride. Your score will go up and down throughout the process, but for most people, you’ll end up with a higher credit score than when you started if you make all of your payments on time. This is why it’s an especially good idea to put your personal loan payments on auto-pay, so that over time you may see an automatic increase in your credit score too.