Will taking out a personal loan improve or hurt your credit score?
You may have heard that applying for new loans or credit accounts can damage your credit score. There’s some truth to that. However, as with most personal finance problems, there is more to it than that.
Personal loans can have some negative effects on your credit score, but they can also be positive catalysts.
With that in mind, here is a brief overview of how the FICO credit scoring formula works. Then we look at the potential impact – both negative and positive – of applying for a personal loan.
How your FICO score works
Before we dive into how a personal loan can affect your credit score, it’s important to have a basic understanding of where your credit score comes from. the FICO score is the most common model used by lenders. It consists of five information categories.
- Payment history (35%): The most heavily weighted category that makes up your FICO score is your bill payment history. Paying your bills on time every month will have a positive impact on your credit score. Since this is such an important category, not Paying your bills on time can a wreak havoc on your credit score.
- Amounts you owe (30%): The amounts of your debt rank second to the importance of your FICO score. However, this does not refer to the actual dollar amounts you owe. your credit relative to your credit limits or original loan balances are more important.
- Credit history length (15%): Longer and more established credit histories are cheaper. That makes sense — someone who’s paid all their bills on time for 10 years has less credit risk than someone who’s paid all their bills on time for a year.
- New Balance (10%): This includes recently opened accounts as well as current loan applications (also known as inquiries). The idea is that applying for a lot of new credit could be a sign of financial trouble.
- Credit mix (10%): This category is more important when your credit history is short and there is not much other information. Lenders want to know that you can handle different types of credit accounts (mortgage, car loan, credit cards, etc.) responsibly, not just one or two.
Possible negative effects of taking out a personal loan
With FICO information categories in mind, let’s go through the potential negative effects of taking out a personal loan.
If you first take out a personal loanyour application appears as a credit request and the credit account as a new credit. So the new credit portion of your FICO score might take a hit.
Most personal lenders allow you to review your interest rates and loan terms on a personal loan without affecting your credit score. So look around. I encourage you to pre-qualify with multiple personal lenders to compare your options.
Once you get past the pre-qualification stage and fill out a loan application, it will trigger a hard loan pulldown. This will appear on your credit report and may affect the new credit portion of your score for a year.
Unless you’ve opened several new credit accounts or applied for all types of credit in the past few months, this impact should be minor. A single loan request or a new account is unlikely to lower your score by more than a few points. You’ll likely only see a big effect if you add the personal loan to several other new loan lines.
Another possible negative effect occurs in the ‘amounts owed’ category. When you first open your personal loan account, you still owe 100% of the original balance. That’s nowhere near as bad as maxing out a credit card account. But it could still cause your score to take a moderate dip.
Positive effects should outweigh negative ones over time
You may have noticed that the potential negative effects of a personal loan are immediate. On the other hand, most long-term effects of a personal loan are positive.
As you make your loan payments over time, you build a strong payment history. This can improve the most important category of FICO scoring information.
Another effect of your payments is that your loan balance steadily decreases, which helps you in the Amounts Owed category. These two categories together make up 65% of your FICO score, so it’s fair to say they outweigh the negative impact of “new credit.”
It’s also worth noting that installment debt is generally better than revolving debt like credit cards. It’s better to owe 80% of your original balance on a personal loan than to use 80% of your available balance on a credit card.
If you’re taking out a personal loan to consolidate credit card debt or another type of revolving debt, shifting your debt from revolving to installment payments can play a role gigantic positive impact. Not only will you replace your revolving debt with installment debt, but you will now have credit accounts with little or no credit.
That’s exactly how it was when I took out a personal loan a few years ago to pay off credit card debt to furnish my new home what happened to me.
Finally, if you have a short credit history, adding a personal loan to the “Loan Mix” category can help you, especially if you don’t have other types of installment debt on your credit report.
Bottom line: what to expect when you take out a personal loan
Every situation is different, and the exact FICO formula is a closely guarded secret. In addition, there are a variety of possible personal loan amounts and terms that you could get. There is no way to predict the exact impact on your credit score when you take out a personal loan.
The most common scenario, assuming you make your loan payments on time, involves a small drop in your credit score after you apply for and get a personal loan. Usually it is less than 10 points. There is likely to be a gradual and noticeable positive shift in the coming months. If you use your personal loan to pay off credit cards, the positive effect can be felt much faster.
In summary, a personal loan will initially cause a barely noticeable drop in your credit score. But in the long run you will see powerful positive effects.
The Best Personal Loans of Rise for 2022
The Ascent team has researched the market to bring you a shortlist of the best personal loan providers. Whether you want to pay off debt faster by lowering your interest rate or need some extra cash to tackle a big purchase, these top tips can help you achieve your financial goals. For the full rundown of The Ascent’s top picks, click here.