How does a personal loan affect credit score? Like most types of credit, it will show up on your credit report and have an impact on your credit score.
When you first take out a personal loan, you’re likely to see a short-term drop in your credit score. If you handle the loan properly, your score will recover, and it could improve over time.
How Credit Scores Are Calculated
Credit scores are determined based on a variety of factors outlined in your credit report. When considering “how does a personal loan affect credit score,” it’s essential to understand that there are numerous formulas used to calculate these scores. These formulas weigh various elements in a specific order, from most to least important, to generate your credit score.
- Payment history
- Amount owed
- Length of credit history
- Credit mix
- New credit
Your new personal loan will affect most of these categories.
Which Factors Does a Personal Loan Affect?
Understanding “how does a personal loan affect credit score” is crucial, as personal loans can impact various aspects of your credit score. Being aware of how a personal loan influences each factor can help you ensure that it doesn’t negatively affect your score and may even improve it over time.
How does a personal loan affect credit score? It’s important to know that getting a personal loan won’t have an immediate impact on your payment history. This is because the initial application and fund disbursement don’t involve any monthly payments. However, once you receive your first bill and for every subsequent month, the personal loan will influence this facet of your credit score.
With every timely payment you make, you’ll add a good mark to your credit report. Timely payments help show that you can be trusted to pay your debts and will improve your score.
A new personal loan means another payment you have to make each month and more opportunities to improve your score. However, it also means more opportunities to miss a payment and damage your credit.
Keep in mind that one missed or late payment has a much bigger impact on your credit than one timely one. It’s essential to make sure you can afford the monthly payments before you get a loan, lest you run into financial trouble and damage your credit.
📖 Learn more: If you’re weighing the option of securing a personal loan, our recent analysis offers insights to guide your choice.
The amount you owe is the second most important component of your credit score.
This aspect of your credit score is split into two pieces: your credit utilization ratio and the simple total of your loan balances.
Credit utilization measures the percentage of your revolving credit limit that you are actually using. Personal loans are installment credit, not revolving credit, so they won’t help or hurt your utilization.
How does a personal loan affect credit score? One significant way is by introducing a new debt to your credit report. The more that you owe overall, the lower your credit score will be. That’s one reason why taking out a new personal loan can cause a short-term drop in your credit score.
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New Credit and Length of Credit History
These factors play a smaller role than your payment history and amount owed when it comes to determining your credit score, but they are still important to consider.
When you’re wondering “how does a personal loan affect credit score,” it’s important to note that most lenders initiate a hard inquiry on your credit during the application process. This means that they ask a credit bureau for a copy of your credit report for the purpose of making a lending decision.
Credit bureaus take note of these hard inquiries and include a record of them on your credit history. Each hard inquiry reduces your credit score by a few points. The impact of these inquiries decreases over time until they drop off your report entirely after two years.
That means that applying for a personal loan, whether or not you’re approved or eventually accept the loan, will cause your score to drop by a few points.
If you accept the loan, it will begin to show up on your credit report. It is a new loan with a short history, which affects the average age of your credit accounts. The longer the average age of your accounts, the better it is for your score.
How much a new loan impacts your score in this way depends on the other items on your credit report. If you have a very young credit report, a new account won’t drop your average age of accounts much. If you have many old accounts, the impact will be small.
If you only have one other account, adding a new one will cut the average age of your credit accounts in half, which can mean a more noticeable drop in your credit score.
As your loan ages, it will begin to have a positive impact on the average age of your credit accounts.
📖 Learn more: If your credit history is holding you back, our guide offers insights into personal loans designed for bad credit scenarios.
Credit mix is a lesser-known factor when considering how a personal loan affects credit score, yet it’s important to note that taking out a personal loan can impact this aspect of your credit rating.
Your credit mix measures the different types of credit you are using. More variety shows that you can handle different types of debt. For example, someone with five credit cards will score lower here than someone with a credit card, mortgage, auto loan, and student debt.
If you get a personal loan and the other accounts on your credit report are all credit cards, you may gain a few points in this factor. Having both revolving accounts and installment accounts active will help your credit mix.
Though your debt-to-income (DTI) ratio doesn’t impact your credit score, it does play a massive part in your ability to qualify for future loans. That makes it essential to think about.
Your DTI ratio is the percentage of your gross income that you must use to cover debt payments each month. The formula is:
Minimum monthly debt payments / Gross monthly income = DTI ratio
So, if you make $5,000 a month, have a $1,500 mortgage payment, $300 student loan payment, and $150 credit card payment, your DTI ratio is 39%.
When you get a personal loan, you’ll get a new bill that you have to pay every month. That increases your DTI ratio. The higher your DTI ratio, the harder it is to get loans. Some loans, such as certain mortgages and car loans, even have hard limits on your DTI ratio to qualify.
A common rule of thumb is to keep your DTI ratio to no more than 43%. Keep this in mind when applying for personal loans, especially if you expect to be applying for a major loan soon.
Should You Pay a Personal Loan Off Ahead of Schedule?
If you have extra money, paying off a personal loan ahead of schedule can be a good idea. You’ll save money on interest and can eliminate a debt, which will help your amounts owed and debt-to-income ratio.
However, before you dedicate extra money to paying off personal debt, ask yourself if there’s a better way to use that money. For example, if you have higher-interest debt (like a credit card balance), paying that loan off first will save you more money.
You might also consider dedicating the money to paying down revolving debt, such as credit card debt. Not only are these debts typically more expensive, but reducing your revolving debt can boost your credit score by lowering your credit utilization ratio.
If your personal loan has a very low-interest rate, it may even make sense to save or invest the money instead. For example, if you are locked in with a low personal loan rate, you might find that some bonds, CDs, or other investments could offer returns higher than the cost of the borrowed money, meaning you’ll come out ahead by investing rather than paying down debt.
Paying off your personal loan on schedule will also keep that account on your credit report longer, improving the length of your credit history and giving you the full impact of your on-time payments. Active accounts have a greater impact on your credit score than closed accounts, so paying the loan on schedule instead of early can help boost your credit.