Banking and Finance

How Does a Personal Loan Affect Your Credit Score in 2022?

Elizabeth
July 27, 2021

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, 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.

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Personal Loan vs. Line of Credit

You might be thinking then, “well then why wouldn’t I just take out a line of credit?” Personal loans and lines of credit both have their pros and cons. Really, it’s just important to understand that there’s a difference between the two.

Personal loans have fixed interest rates and monthly payments, while lines of credit have variable interest rates and allow you to borrow as much or as little as you need. Personal loans are better for one-time expenses, such as a home renovation, while lines of credit are better for ongoing expenses, such as business costs.

Ultimately, the best choice for you depends on your specific financial needs.

Does a Personal Loan Hurt Your Credit Score?

As mentioned above, personal loans can actually help improve your credit score as they get reported to credit bureaus as installment loans. Installment loans help to improve your credit mix, which is one of the factors that make up your credit score. 

Additionally, personal loans can help to improve your debt-to-income ratio, another important factor in determining your credit score. Of course, it's important to keep up with your personal loan payments in order to see the positive impact on your credit score. Missing payments can damage your credit score, so it's important to stay on top of them.

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?

It's simple: 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, so by making timely personal loan payments, you're giving your score a boost. 

Additionally, personal loans can help you diversify your credit mix, which is also factored into your credit score calculation. So, if you don't have much other credit history to speak of, taking out a personal loan and making your payments on time can help give your score a nice bump. 

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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?

The answer is, it depends. 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, if you have an installment loan, such as a car loan or mortgage, then paying off the loan 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.

Do Personal Loans Build Credit?

They can, yes! Personal loans are reported to the credit bureaus, just like any other type of loan. If you make your payments on time and in full, it will improve your credit score. 

On the other hand, if you miss payments or default on the loan, it will damage your credit score. So if you're thinking about taking out a personal loan, be sure to make your payments on time and in full to build your credit.

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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 My Car?

We know. It doesn’t make sense! Some people see their credit score drop after paying off a big loan such as an auto loan or personal 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! This includes credit builder loans, which are designed for people with little to no credit history (such as immigrants or college students).

Many lenders actually specialize in working with people with bad credit, and they can offer competitive rates and terms. So don’t despair if your credit isn’t perfect. There are still plenty of personal loan options available.

Manage Your Finances With Cheese

Want to stay on top of your finances so that you either won’t need a personal loan or will be able to snag the best interest rates when you do apply for one? 

Stay tuned! We’re building a brand new credit builder product just for you.