SrdjanPav/ Getty Images; Illustration by Austin Courregé/Bankrate
Key takeaways
- A loan application can temporarily lower your credit score due to the required hard credit check.
- Though this drop is temporary, it isn't the only way a personal loan can hurt your score.
- Personal loans can also positively affect your score over time by contributing to your credit mix and payment history, among other factors.
When you apply for any type of credit, lenders must perform a hard credit check to view your credit file. This check causes a temporary drop in your credit score. Personal loans are no exception to this rule — applying for one will knock your score by a few points.
But there’s an upside: Making timely monthly payments can also mean good news for your credit score over time. Your payment history, which is the largest component of your credit score, will improve. You can also boost your credit score by consolidating debt from revolving credit, like credit cards, which lowers your credit utilization ratio. Just make sure not to fill those credit cards right back up or you’ll undo the progress made and have more monthly payments.
How loan applications impact your credit
Before approving you for a loan, lenders must first check your creditworthiness and financial health. They do this through a credit inquiry or credit check. These checks can be “soft” or “hard,” depending on the purpose of the check.
Soft credit check
A soft credit inquiry or check is more of a general background check than anything else, so it doesn’t impact your credit. Because of this, it can be done with or without your consent.
Some personal loan lenders offer soft credit checks to see what you may qualify for. This allows borrowers to view realistic offers without having to fill out a formal application and go through a hard credit check.
Hard credit check
When you apply for a personal loan, lenders will run a hard credit check to have access to your credit report and history. Hard credit checks temporarily lower your credit score by as much as 10 points. But if you have excellent credit, applying for a loan will most likely make your score drop by five points or less.
Though your credit score will typically recover within a few months, the hard credit check will stay on your credit report for up to two years. Because of this, lenders must ask for your consent before doing this type of inquiry.
Bankrate tip
You are required to submit additional documents when you apply for a personal loan, including proof of identity, employer and income verification and proof of address. Have these on hand when you apply.
How personal loans could help your credit
Under the right circ*mstances and when used responsibly, a personal loan can positively impact your credit score in a few ways.
- Give you a better credit mix: Adding various types of lending products to your portfolio helps keep your credit score high as long as you stay on top of payments. It is generally a good idea to have a mix of installment loans and revolving credit, as credit mix accounts for 10 percent of your FICO score.
- Make debt more manageable: If you use a personal loan to consolidate debt, you can generally take advantage of lower interest rates than you’d get with credit cards. With a lower interest rate, you may be able to pay down outstanding debt faster, which will improve your credit score.
- Boost your payment history: A personal loan can help establish a positive payment history when made in full and on time. Positive payment history makes up 35 percent of your FICO score, the largest category in determining your score.
- Reduce your credit utilization ratio: A personal loan does not affect your credit utilization ratio. However, using one to pay off revolving credit card debt could lower this measure, resulting in a higher score.
How personal loans could hurt your credit
Just like any other credit products, personal loans could potentially hurt your credit in several ways.
- Hard inquiry on your credit: Due to the hard credit check, you will likely see a short-term drop in your credit score when you formally apply for the loan.
- Late or missed payments could lower your score: If your payment is late by 30 days or more, the lender will report it to the credit bureaus. This negative mark can stay on your credit report for approximately seven years and will ding your score. If enough time has passed and the account goes to collections, your credit score could drop between 90 and 110 points.
- Increase your debt load: When you take out a loan, it increases the amount of debt you have. If you already have a high debt load, taking on a loan can limit your future access to credit, as lenders will see you as a greater risk.
- Impact length of credit history: Opening a new loan account can lower the average age of your credit. This could result in a small dip in your score, as length of credit history accounts for 15 percent of your FICO score.
What to consider before taking out a personal loan
Before taking out a loan, consider the benefits and drawbacks of adding another monthly bill to your budget.
- Reason for the loan: Personal loan lenders tend to offer different interest rates depending on the purpose of your loan. For instance, personal loans to consolidate debt may have a lower interest rate compared to one used to finance a vacation.
- How much it will add to your monthly costs: Calculate how much a personal loan will take out of your monthly budget. If you can’t comfortably afford it, you may want to hold off on taking one out.
- Your credit score and history: Do you have a good credit score and healthy habits with your credit? If not, you can take steps to improve your credit score before applying.
- Your debt-to-income ratio: Your debt-to-income (DTI) ratio measures your monthly debt relative to your monthly income. Generally, the higher the DTI ratio, the less likely you will qualify for a loan.
- All of your options: Shopping around for the best personal loan for you is one of the most important steps to take. Each lender offers different rates, fees and conditions to account for. It’s especially important to prequalify if you have less-than-perfect credit — getting the best bad credit loan rate can save you hundreds in interest.
The bottom line
Personal loans can be a great tool that can help you improve your credit score, consolidate debt or pay off major expenses. However, knowing how applying for a loan can affect your credit score is important.
While you may experience a short-term dip when you submit your application, you could improve your credit score over the long run by making timely payments and using your loan funds to pay down existing debt. Finally, before you apply, shop around for the best personal loan rates to get the financing that fits your situation.
