Are you considering a personal loan?
Are you worried about how applying for or borrowing a personal loan will affect your credit?
That is certainly a valid concern.
Spoiler: It does.
In America, it can feel like credit is the king, judge, and executioner. Almost all financial decisions you make either depend on your credit or affect it. To get to the bottom of this, we asked personal finance experts for advice about how and when a personal loan affects your credit, both in the short term and long term.
Credit score recap
Your credit score is critical when determining your personal loan eligibility. It provides lenders a snapshot of your spending habits and history of repaying financial obligations. A lower credit score is a red flag and signals a risk to the lender that an applicant might not have the means to fulfill his or her monthly repayment obligations with the loan. Conversely, a good credit score gives the lender confidence that you will make on-time payments every month.
To start, let's recap about general credit scoring, with the help of Lisa Johanning, Vice President of Consumer Lending at Axiom Bank, N.A. She says, "Payment history has the highest impact on your score, so being on time with your payments has the highest positive impact on your score (35 percent). This is followed by amounts owed (30 percent), length of credit history (15 percent) and credit mix (10 percent), which describes what types of accounts make up your credit (installment loans, mortgages and revolving loans, such as credit cards). Requests for new credit (inquiries) only account for 10 percent of the FICO score."
With that basic recap, let's jump into the personal loans. We will cover:
- Personal loan basics
- Short-term credit score effects from your personal loan
- Long-term credit score effects from your personal loan
1. Personal loan basics
Personal loans, also known as personal installment loans, are increasingly popular in the lending industry, due to increased accessibility made available by FinTech companies and online lenders.
Annastasia Kamwithi is an editor for Social Fish, a site dedicated to helping millennials take control of their finances. She shares some background on this type of loan: "A personal loan is a type of credit that is usually issued by banks, digital lenders, or credit unions to help you with some immediate needs such as making a big purchase, consolidating your small loans into one, starting a business, etc."
What is the draw to borrow money through a personal loan, as opposed to credit cards or other loans?
Personal loans generally have lower interest rates than short-term, payday loans, and even credit cards. While these are most often unsecured personal loans, though some lenders give the option to borrow a secured loan by putting up collateral. Another common factor seen in personal loans is the use of fees like an origination fee, built into the loan's repayment terms, and the total amount that you borrow and have to repay. On top of that, your repayment terms are built around a fixed rate. Meaning, your interest rate, and monthly payments are planned out in advance, to the penny, for the entire loan term. Your annual percentage rate (APR) won't change with fixed-rate loans. This is in contrast to most credit card accounts, which have a variable rate, depending on the market and financial institution.
"The reason to get a personal loan is that you have credit card debt or other high-interest rate debt that you want to get rid of," explains Jake Sensiba, Financial Advisor for CRG Financial Services, Inc.
He's right. Debt consolidation loans are a big deal. More than half of personal loans are taken out to consolidate or manage existing debt like high-interest credit card debt. The rest of the top five reasons that people get a personal loan are varied:
- Debt consolidation
- Home improvement
- Educational expenses
- Starting a business
- Medical expenses
"Most personal loans," continues Sensiba, "though it depends on your credit score, offer lower rates of interest than credit cards. You save money on the interest. That's the draw." Especially when you are using it as a consolidation loan to pay off a high-interest revolving credit card balance.
However, he warns, "Individuals with lower credit scores will get less favorable terms (interest rates)." This is especially true for those of us with "not good credit" who are just able to meet a lender's minimum credit score requirements. What else is new?
Personal loan pre-qualification
When you are looking into a personal loan, you should know that many lenders offer to do a preliminary check to see what kind of rates you may be eligible for, including your loan amounts and loan terms. "In general," explains Freddie Huynh, Vice President of credit risk analytics for Freedom Financial Network, "when someone calls an independent lender to inquire about a personal loan and wants to check rates, that involves only a soft credit check. Soft inquiries are inquiries that do not affect credit reports or scores. They happen when you check your own credit reports or when a company check your credit reports for background/reference."
While "Most lenders will pre-qualify you for a personal loan by doing a soft credit check," warns Kamwithi, "Some lenders, however, will not do a soft-check. Therefore, ensure you look for one that does this, as it SHALL NOT AFFECT YOUR CREDIT SCORE." Look for wording like:
When you are shopping for rates, if you don't see buzzwords like these, ask questions. You don't want to have an unnecessary, negative impact on your credit score.
Personal loan application
"Compared to loan pre-qualification, actually applying for a personal loan is a whole different ball game," explains Kamwithi. "When you apply for a personal loan, it will trigger a hard credit check." It's important to be aware that the very act of applying for a loan will have a direct impact on your credit.
Let's check out the different ways that applying for a personal loan can affect your credit score in the short-term. We will break this down into the different credit score factors (as listed in the graphic above).
2. Short-term effects of a personal loan
"As far as credit history," advises Jason Orlicek, Senior Vice President and Loan Manager for Signature Bank of Arkansas, "you must actually open a new loan account to create a new ‘history' item and then your ability to make payments on time will follow and have a more long-term effect on your score. There is a balance between having enough credit and too much."
Opening a new personal loan helps to establish more payment history, but you will see this impact in the long term, rather than an immediate boost to your credit score.
"Having a higher percentage of available credit used (credit cards, lines of credit) typically decreases the score," adds Orlicek.
If you are using the new loan to consolidate debt, this can affect your score by reducing your utilization ratio.
As Huynh explains, "One area in which a personal loan can have a positive impact on credit is when a consumer uses it to consolidate and eliminate credit card debt. Along with the greater simplicity of making just one monthly payment, personal loan interest rates are generally a bit lower than credit card interest rates. Some personal loan lenders even offer a discounted rate if you use the proceeds to repay credit card debt and transfer the loan proceeds directly to creditors."
"Consolidating all of your personal debts can help in improving your credit by lowering your credit utilization," explains Kamwithi. "Your credit utilization ratio refers to the amount of credit available for you to use."
Length of credit history
"Opening a new credit account lowers your average credit age," explains Sensiba. "Older credit accounts are better for your score."
Charlie Scanlon, President of Phoenix Credit Consultants explains how this works: "The loan, if approved, can impact your credit score by diluting your credit history, i.e., the average age of the accounts that are reporting on your credit report. The newer account is averaged in with your other accounts.
Let's say you have a single credit card and you have had it for a year. When you add the new loan, it will dilute your credit history's age from a year to six months. As the new loan takes on age, it will help you in this scoring category." However, its immediate effect may be negative if you have few accounts open, especially if they are relatively new.
The New Credit category makes up only about 10 percent of your FICO score. This category is made up of several factors:
According to FICO, "Inquiries remain on your credit report for two years, although FICO® Scores only consider inquiries from the last 12 months. FICO Scores have been carefully designed to count only those inquiries that truly impact credit risk, as not all inquiries are related to credit risk."
So, new credit inquiries go straight to your credit report. The real question is: How much do they affect your actual credit score?
"Applying for any type of loan will impact your credit, even if minutely," says Mike Scott, Senior Loan Originator at Independent Bank. "Why? When a creditor pulls your credit report, it can lower your credit score, typically by two points. The more inquiries on your report, the lower your score gets."
"In the very shortest term," explains Scanlon, "the impact applying for a personal loan will depend upon whether [the lender] runs your credit and whether they obtain your credit from all three of the national credit bureaus or only one of the three. Credit unions, for example, will often only pull your credit from one bureau."
This is important because it's common to have a different FICO score with each of the major bureaus: Equifax, Experian, and TransUnion; and if they only do a hard pull from one credit reporting agency, the hard pull will only affect your score with one of the agencies, not all three.
You should know your credit score before applying for loans. If you are applying for a personal loan with local credit unions, it may be helpful to ask which they pull from, so that you can play to your strengths.
"Every time your credit is pulled, there is typically a small decrease in your credit score in the short term as one of the factors in determining your score is how many times your credit is pulled," explains Orlicek. The effect of the hard inquiry hits you, whether your application is approved or denied.
Johanning explains why: "The reason the credit score drops is based on the theory that as you take on more debt, the odds of failing to repay loans rise. So as the risk rises (more inquiries for credit), the score drops. "
"While it does not affect your credit score much," says Logan Allec, a CPA and owner of personal finance site Money Done Right, "this can add up if you have a lot of hard inquiries." Additionally, "Too many new accounts opened in a short period tends to decrease the score," says Orlicek.
"Be very cautious about applying for multiple loans at the same time," warns Jared Weitz, CEO and Founder of United Capital Source Inc., this will begin to drive your credit score down. After a hard inquiry has been pulled from a credit application, wait six months before applying again to ensure your score has had time to recover. "
A hard inquiry doesn't affect everyone equally. Chad Rixse, CRPS®, Director of Financial Planning at Forefront Wealth Partners explains, "In general, hard inquiries are only detrimental to those with spotty credit histories, such as poor payment history, high utilization rates, and limited credit mix. For those with extensive credit histories, on the other hand, a single hard inquiry is unlikely to have any effect at all."
When it comes to credit mix, a personal loan can be a positive way to add some variety to your credit history.
"If your new loan is a type of account that you don't presently have," Scanlon advises, "it can help your score by adding to your mixture of accounts, or diversity of accounts. If your loan is one that you are paying back in monthly payments, it will likely report as an installment account. This is different from a credit card account, which is a revolving account and will boost your scores because of the additional, new type of borrowing. The credit scoring algorithm likes to see that consumers can manage different types of accounts, therefore it rewards the consumer for having a variety of different types of accounts."
As Allec explains, "If you add a personal loan, then you will increase your score due to a change in a variety of credit. This is a positive benefit of applying for a personal loan, and many people will take out small loans they lend to themselves to vary their credit and increase their score."
3. Long-term effects of a personal loan
Just as there are short term effects to your credit report when you apply for and take out a personal loan, there are also long-term effects. These can be good or bad for you and your all-powerful credit score, depending on your behavior.
"Obviously, the most important thing about a loan when it comes to your credit is repaying the loan in a timely fashion," says Scanlon. "Your payment history, or how timely your bills that report to the credit bureaus are paid, makes up 35 percent of your credit score." This is the category where the most potential benefits of a personal loan are located.
"Most lenders will report your repayment history to all three credit bureaus, i.e., Experian, TransUnion, and Equifax," says Kamwithi. "Having a lender that will report to all of them means that you shall have a more consistent credit report, regardless of which bureau you use for retrieval." This is the biggest opportunity to improve your credit score with a personal loan.
It's important to establish a positive record of on-time loan repayment. Huynh elaborates, "If someone takes out a personal loan, making all payments as required, on time, is critical to maintaining and improving credit profiles – just as is the case with any loan (mortgage, car, student loan) or bill (utility, phone, etc.). One effect of making all personal loan payments on time may be a positive impact on credit profiles."
Igor Mitic, Co-founder of Fortunly.com adds that this long-term boost to your score is helpful, "Especially if you consolidate debts — such as credit card or auto loans — into one personal loan that you pay consistently over time."
Late payments can have a large impact on your FICO score. Kamwithi explains, "If you are going to miss your personal loan payment by a few days, that will not affect your credit report or score, but if you miss payments with more than 30 days, this will be reported to all the main credit bureaus, and there shall be notable damage to your credit score. "
How much damage is possible?
Weitz says, "It is possible to go from having excellent credit to a fair credit score (100 point drop) based on 30-day delinquency."
On top of that, Scanlon says, "Payments which are 90 days late or more on the loan can do more substantial and longer-lasting damage."
"Late payment on your account in the past 6–12 months will have a much harsher effect than some late payments 4–5 years ago," explains Scott. Sometimes life happens and we make late payments, but "What the bureaus are looking for is the pattern of payment."
"The amount of debt one carries directly impacts credit profiles and scores," explains Huynh. "It's explained in terms of percentage utilization (which you want to minimize) and credit available (which you want to maximize).
To explain, if you have a credit card with a limit of $9,000, and you owe $3,000 on it, that's a 33 percent utilization.
Since credit card utilization can play an important part in credit score determination, consumers will be smart to keep credit card balances and utilization low. Therefore, if you can eliminate credit card debt through a personal loan, you should see a positive effect in credit profiles."
According to Sensiba, in the long term, personal loans can be good for your credit, "as long as you are responsible. If you get a personal loan to pay off credit card debt and go right back to paying for items with your credit card, it didn't make much sense to do the personal loan then. It can be good because you get rid of the outstanding balance on your credit card, your credit utilization will improve (high-impact), and your debts are consolidated so they'll be easier to manage. "
Length of credit history
"Accounts that are open less than 12 months tend to pull a score down," explains Scott. "One of the factors impacting a credit score is how long accounts have been established. It is better to have only one account which was open for three years than it is to have ten accounts which were each open for four months. Credit bureaus want to see the LONG-TERM willingness to repay, with the idea that anyone can make a payment for a few months. Once the account has been opened for 12 months or so, the impact on a score tends to be more neutral, and the longer the account stays open, the more it can raise your score, at least if you pay it on time."
Once you have had your personal loan open for a year, it is no longer considered in the new credit factor and will likely not have any further impact.
If this is the only installment debt on your report, it may hurt your credit score just a bit when repayment is completed and closed, but the positive impact on your current debt balances, and the chance to improve your credit by establishing positive payment history should outweigh this temporary setback.
The bottom line
Once you finish paying off an installment loan, like a personal loan, information about the loan and your repayment stays on your credit report for up to ten years; seven years if you made any late payments, and ten if you were in good standing. It can affect you for good or bad, depending on your habits.
It doesn't just disappear when you repay the loan.
So, how do you decide whether a personal loan is right for you?
Mitic suggests, "it's important to weigh the short- and long-term benefits of applying for a personal loan before you apply. If your goal is to build credit, take out a personal loan that you can realistically pay off to increase your eligibility for bigger personal loans and long-term financing options in the future."
Evaluate whether a personal loan is in your best interest or if there are alternative ways to meet your financial needs. If a personal loan does indeed seem like your best option, do plenty of research in advance to ensure the lender you use is right for you.
Check out our personal loan reviews to help in your decision-making process, whether you are looking into borrowing a debt consolidation loan, home improvement loan, or any other type of personal loan.
*Josh McFadden also contributed to this piece.