Will personal loans impact my credit score?

Personal loans are used to finance a wide array of different activities and life events, from consolidating debt to remodeling a home. But as is the case with any type of loan or line of credit, anyone looking to take out a personal loan should consider how doing so will impact their credit score.

If you’re wondering whether a personal loan will impact your credit score, the answer is fairly straightforward. As is the case with nearly any other type of loan, taking out a personal loan will have an effect on your credit. Everything from applying for a loan to making your payments can cause your score to change without warning.

But while we’re often concerned about the negative impacts of applying for a loan or opening a new line of credit, we tend to overlook the fact that being a responsible loan holder can actually improve your creditworthiness.

In this article, we’ll take a closer look at the impacts—both positive and negative—that personal loans typically have on people’s credit so you can be more knowledgeable about your finances.

What is a Personal Loan?

Before we can really discuss the impacts of personal loans on credit scores, we first need to get on the same page about what a personal loan even is.

Personal loans can take many forms, but most people use them when they want a relatively low-cost way to obtain financing that falls out of the scope of something like a home mortgage or a student loan.

Of course, there are some high interest rate personal loans out there, so you have to do your own due diligence when shopping for them to ensure that you get a good deal. But most personal loans have lower interest rates of between 3% to 8%. These rates are substantially lower than the 15% to 20% interest rate you get with most credit cards and the 25% to 30% rates you typically get with predatory payday loans.

Personal loans work much like any other loan. You first need to get approved for the loan from a loan provider (normally a bank or financial institution) for a specific purpose. You can typically use a personal loan for nearly anything you’d like from home repairs to consolidating debt, but some lenders might have restrictions on what you can use the funds for.

If you’re approved for a personal loan, you’ll be responsible for paying back the funds based on the terms of your loan agreement. Every loan is different, but personal loan payments are typically made monthly.

You’ll need to pay back both the principal balance (how much you borrowed) and any interest on that principal on time each month. If you don’t, you could face late fees and service charges or you could even have your debt sent to collections—yikes!

This isn’t to say that personal loans are necessarily a bad thing. There are times and places where personal loans make sense for people to use (contact a financial coach or advisor if you want specific guidance on what’s right for you). But what’s important is that anyone signing up for a loan knows precisely what they’re getting themselves into.

How Personal Loans Impact Credit Scores

By now, you know the basics of what a personal loan is and how it works. But how do these loans impact your credit score? Let’s take a look at some of the potential positive and negative effects of personal loans.

Potential Positive Effects of Personal Loans

There are a few potential positive impacts of personal loans on credit scores, including:

• Can Help You Establish a Responsible Credit History – Credit rating bureaus don’t tell us specifically how they calculate credit scores, but we do know that having a lengthy history of responsibly paying back your debts usually leads to a higher credit rating. Taking out a loan and making your payments on time and in full every month can help you build a responsible credit history. Of course, if you don’t make your payments on time and in full every month, you can quickly hurt your score, too.

• May Improve Your Credit Mix – Creditors typically like to lend money to people who are able to responsibly manage a wide array of different types of credit. For example, a credit card is a type of revolving credit, which is basically a standing agreement that lets you borrow a certain amount of money each month so long as you pay it back. Being able to manage revolving credit is good, but some creditors also like to see that you can handle installment credit, too. Installment credit, which is effectively a loan, involves borrowing a lump sum up front and then repaying that debt over time. This shows a different kind of reliability as a borrower to creditors, so responsible management of installment credit can help improve your credit score over time.

• Might Be Used to Consolidate & Pay Off Debt – Some people use personal loans to consolidate other debt, which can indirectly help improve your credit score. Consolidating debt on its own doesn't necessarily have a positive impact on your credit. But if consolidating debt from various lenders into one loan makes it easier to pay off your debt over time, then this can often help improve your credit rating. Again, if you don’t manage your debt consolidation loan responsibly, it can hurt your credit. But paying off debt is typically a good thing in the eyes of credit bureaus.

Potential Negative Effects of Personal Loans

As is the case with any kind of line of credit, there are potential negative effects of personal loans. Some of these negative effects can be quite detrimental to your financial life, so it’s vital that you fully consider your ability to repay your debts in a timely manner before you sign any loan agreements.

There are many potential negative consequences of personal loans, including:

• Initial Decreases in Your Credit Score – Many people find that their credit score dips by 5 to 15 points in the months after they apply for a personal loan. This doesn’t happen to everyone, but you’ll generally see some sort of decrease in your credit rating after you open a new line of credit. That’s because lenders almost always do a hard inquiry on your credit score during your loan application. This hard inquiry stays on your report for about 2 years and it can warn lenders off of giving you more credit out of fear that you won’t be able to pay off all that debt. Luckily, with responsible repayment, most credit scores recover within a few months to a year of a hard inquiry.

• Added Costs & Interest Charges – Although it’s true that personal loans typically have lower interest rates than credit cards and payday loans, they’re definitely not cheap. Borrowing money means that you’ll end up paying more over time than you would have if you had the cash on hand to finance your endeavours in the first place. To some degree, this is just the cost of doing business in our modern world, but it’s something to keep in mind before you shop for a loan.

• Potential Long-Term Negative Financial Consequences – Responsibly paying back your loan by making on-time payments in full each month can make you a worthy borrower in the eyes of financial institutions and lenders. But missing even a single payment on your personal loan can tarnish your credit score for years. Failing to pay back your loan (i.e., defaulting on your loan) can cause your credit to drop by hundreds of points, especially if your debt ends up in collections or you have to file for bankruptcy. As a result, you should never borrow more than you can repay. If you’re not sure how much you can afford to borrow, contact a financial coach or financial advisor.

Can Personal Loans Boost Credit Scores?

When we think about the impact that personal loans can have on our credit scores, our minds often wander to all of the negative consequences that can arise if we miss loan payments or fail to pay back our debt.

That said, while it’s certainly true that personal loans—like all financial tools—come with a sizable amount of risk, there are potential benefits of these loans for people who can manage their debt responsibly.

For example, paying back your loan on time and never missing a payment can actually help boost your credit score in the long run. But missing even a single payment can cause your score to plummet.

At the end of the day, it’s up to you to decide if you’re ready for the responsibility that comes with a personal loan. There are risks and rewards involved with personal loans, so always consider how your debt repayment plan fits into your budget before you sign any contracts or loan agreements.