How Does a Personal Loan Affect Your Credit Score in 2023?
Have a personal loan? You’re not alone! Over 20 million Americans had personal loans as of the beginning of 2022. Most people use these loans to fund anything from higher education expenses, to emergency costs, or even everyday purchases.
However, did you know that a personal loan could affect your credit score? Mostly, they can actually help improve your credit score! This is because personal loans are typically installment loans, which means they're reported to the credit bureaus as such.
If you have a personal loan or are considering taking out a personal loan this year, here’s what to know about how that decision could ultimately impact your credit score.
What is a Personal Loan?
A personal loan is a type of loan that can be used for a variety of purposes. Unlike other loans, such as auto loans or mortgages, personal loans are not secured by collateral. This means that if you default on the loan, the lender cannot take your car or home in order to recoup their losses.
What can you use these types of loans for? Just about anything, including consolidating debt, funding a large purchase, or paying for unexpected expenses. Because personal loans are unsecured, they typically have higher interest rates than secured loans. However, personal loans can be a good option for those who do not have collateral and need flexibility in how they use the loan.
Personal Loan vs. Line of Credit
You might be thinking, “why wouldn’t I just take out a line of credit?” Personal loans and lines of credit both have their pros and cons. It’s important to understand that there’s a difference between the two.
- Personal loans have fixed interest rates and monthly payments; they are better for one-time expenses, such as a home renovation.
- Lines of credit have variable interest rates and allow you to borrow as much or as little as you need; they are better for ongoing expenses, such as business costs.
How Can a Personal Loan Help Build Your Credit Score?
While we don’t necessarily suggest taking out a personal loan specifically to improve your score, credit builder loans can be a great option for those with little to no credit history. If you were already planning on taking out a personal loan, though, how can that help you build your credit score?
- Personal loans help build positive payment history. When you make your loan payments on time and in full, it will help improve your credit score. Your payment history is the biggest factor in determining your credit score, as shown in the picture below, it accounts for 35% of your credit score. Therefore, by making timely personal loan payments, you're giving your score a boost.
- Personal loans help diversify your credit mix. Credit mix is also factored into your credit score calculation; it accounts for 10% of your credit score. A personal loan can add installment credit to your credit report; this is a different type of credit from the revolving credit that credit cards belong to. So, if you don't have much credit history to speak of, taking out a personal loan and making your payments on time can help give your score a nice bump.
- A personal loan can lower your credit utilization. If you use a personal loan to pay off your credit cards (revolving credit accounts for credit utilization), you are replacing the revolving credit with another type of credit (installment loan), which will lower your credit utilization ratio.
How Does a Personal Loan Hurt Your Credit Score?
Yes, a personal loan can hurt your credit score in these scenarios:
- Lenders perform a hard pull on your credit report. When you apply for a personal loan, the lender will do a credit check on you, and mostly it is a hard inquiry (which drops your credit) rather than a soft inquiry (which doesn’t affect your credit). Nevertheless, a credit score decrease caused by a hard pull may only last for a few months.
- You miss a loan repayment. If you miss a loan repayment, or if your payment is 30 days late, the lenders will report them to the credit bureaus, which will negatively affect your credit score.
Getting a Personal Loan: When It Makes Sense
Still not sure if getting a personal loan is right for you? There are a few different situations where it might be a good idea to consider taking out a personal loan.
For example, if you're looking to consolidate your debt, a personal loan could help you save money on interest payments. Or, if you're looking to make a large purchase, like a new car or a home renovation, a personal loan could give you the extra cash you need.
Of course, there are also a few things to keep in mind before taking out a personal loan. Make sure you understand the terms of your loan, and be sure to shop around for the best rate.
FAQs About Personal Loans & Credit Scores
Taking out a personal loan, especially if it is a large one, is a big decision. Here are some of the most commonly asked questions about personal loans and credit scores to help make that decision easier.
Does Paying Off a Loan Early Hurt Credit?
If you have a revolving line of credit, such as a credit card, then paying off your balance in full each month will actually help your credit score.
On the other hand, paying off a personal loan or other installment loans such as auto loans and mortgage loans early may hurt your credit score. That's because when you pay off an installment loan ahead of schedule, you're effectively closing the account, and that can ding your score.
So if you're thinking about paying off a loan early, be sure to check with your lender first to see how it will affect your credit.
What Credit Score is Needed for a Personal Loan?
While there are definitely loans for people with bad credit, you’ll typically need at least a score of 700 to start getting good interest rates on personal loans.
Why Did My Credit Score Drop After Paying Off a Personal Loan?
Some people see their credit score drop after paying off a big loan such as or a personal loan or an auto loan. Why is this? It’s likely due to the closing of an account.
Another reason may be that you're now carrying less debt overall. While this may seem like a good thing, it can actually have a negative impact on your score. That's because a low debt-to-credit ratio is one of the factors that lenders look at when considering a loan.
Are There Personal Loans for Bad Credit?
Yes! Some lenders provide personal loans for bad credit. These loans can be secured loans, which are backed by collateral such as a house or a car, or they can be unsecured loans with high interest rates. Consider carefully before you apply for a loan for bad credit. If it comes with high interest rates, it might cause you a lot of effort to repay it.
Build Your Credit Before Getting a Personal Loan
Overall, it might not be worth it to get a personal loan if you have bad credit. So building your credit before getting a personal loan can be a good choice. You might want to consider credit builder loans. Credit builder loans are designed for people with little to no credit history, such as immigrants, college students or people who need to rebuild their credit scores. They work in the way that you make payments in advance, and get the funds after a loan term ends. In this way, the lenders can report your on-time payments to the credit bureaus, which can help you build a positive payment history.
Any recommendations? Check out the Cheese Credit Builder. With no credit check and no upfront fees, Cheese welcomes everyone in need to join. Plus, the auto-save function makes you rest assured to avoid missed or late payments. Sign up here to start building your credit and make all your goals possible!