How personal loans affect credit scores

Personal loans can have an impact on your credit score. (iStock)

Sometimes life throws an unexpected expense at you like a medical bill or a necessary home repair. In times like those, taking out a personal loan may be the answer.

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However, it’s important to realize that personal loans can have an impact on your credit score, either positively or negatively. With that in mind, below is an explanation of what these loans are, how they can impact your score, and what you can do to come out on top.

What is a personal loan?

A personal loan is a type of consumer loan that can be put towards just about any purpose. Typically, they’re used to consolidate debt or to pay off large, one-time expenses.

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Since personal loans are unsecured, meaning that they’re not attached to an asset that can be repossessed if you default on your payments, your ability to qualify is based almost entirely on your income and your credit score.

How a personal loan can positively affect your score

Fortunately, if handled correctly, a personal loan can positively impact your credit score. A personal loan can affect your score in the following ways:

  • Building your payment history. Do your best to make your payments on time and in full in order to have the greatest positive impact on your payment history.
  • Contributing to a better credit mix. Personal loans are installment loans, meaning that they’re paid back in the form of regular monthly payments. They’re considered a different type of debt than revolving credit - or credit cards - and can help you build a more diverse portfolio. 
  • Lowering your credit utilization ratio. Installment loans aren’t counted toward your credit utilization ratio, so if you use a personal loan to consolidate your credit card debt, it can lower your ratio and boost your score.

How a personal loan can negatively affect your score 

That said, unfortunately, a personal loan can also have a negative impact on your score. Here's how:

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  • It creates a hard inquiry on your report. Hard inquiries are created every time a lender pulls your credit report as part of their decision-making process. A new, hard inquiry can stay on your report for two years and may negatively impact your score, especially if you have multiple inquiries at once.
  • It can create more debt. If you’re not taking out a personal loan to pay off credit cards, taking on new debt can raise your debt-to-income ratio.
  • There are additional fees. Personal loans come with high-interest rates, which can add up. In addition, you’ll likely have to pay some fees in order to close on the loan.

What you can do to control the impact

In terms of what you can do to ensure the impact of a personal loan on your credit score is beneficial, the advice is simple:

  • Do a credit check first. Consumers are entitled to one free credit report per year from AnnualCreditReport.com. It can guide you on whether or not taking out a personal loan is advisable.  
  • Make your payments on time. Be sure to pay them in full, too.