- Taking out a personal loan can harm or improve your credit score, depending on your stage of borrowing and your behavior.
- You will add a hard credit inquiry to your credit report when you apply for a personal loan, which temporarily hurts your credit score.
- If you always make on-time payments, you’ll boost your credit score no matter what.
There is a lot of confusion surrounding how credit scores work and how taking on debt can affect them. When you take out credit, you take chances. If you take the right steps, you can help improve your credit score, but a misstep can hurt your credit score.
If you need to borrow money to cover a more general expense, you may find that a personal loan fits your needs, since they can be used to cover a wide variety of expenses. Do personal loans hurt your credit score? Keep reading to find out.
How applying for a personal loan can hurt your credit score
When you formally apply for any form of credit, you trigger a hard inquiry on your credit report. This is unavoidable. It is avoidable, however, to trigger too many credit applications.
To help protect your credit, it’s a good idea to look for lenders who make it possible to prequalify. When you prequalify with a lender, you can get a general idea of what type of lending products and loan terms you’ll qualify for without fully applying. This is known as a soft credit inquiry and it doesn’t harm your credit score. That way, you don't have to waste a hard inquiry on a loan you won’t qualify for or don’t want to accept.
Another good rule of thumb when applying for lending products is to try to apply with multiple lenders or financial institutions in a short period of time (one to two weeks is ideal). Credit scoring models recognize that you’re shopping around for the best deal and won’t hold this against you by adding multiple hard inquiries to your credit report. A single hard inquiry will only harm your credit score for a few months, whereas multiple hard inquiries can do more damage.
How paying back a personal loan can help your credit score
Before you take out a personal loan, it’s important to have a plan for paying it back. After all, paying your loan back on time is massively important if you want to keep your credit score healthy. Conversely, missing a payment has the strongest impact on your credit score, as payment history makes up 35% of your score.
Setting up automatic payments on your debt helps to make sure you do not miss your monthly dues. Just confirm you have the savings and cash-flow to cover your minimum loan payment, or you risk facing your bank’s overdraft fees.
Repaying your personal loan according to its established term (typically two to five years) has a fairly black-and-white effect on your credit. Paying off a personal loan early, however, can hurt your credit score for two main reasons—credit card utilization and your average age of credit.
Credit utilization is the percent of credit that you currently use, compared to the total credit you have available to use. So by closing a credit card, you will reduce your total available credit, which can lower your credit score. Credit utilization makes up 30% of your credit score, so this is a big deal.
Average age of credit accounts for 15% of your credit score. The longer your credit history, the more your score will benefit. By closing a credit account that has been open for a long time, you can reduce the average age of the accounts on your credit report, especially if the account you closed was your oldest account.
Not making your loan payments on time has a more cut-and-dried impact on your credit. Carrying a balance on credit cards and missing personal loan payments are the two biggest—and most common—credit mistakes, according to finance and accounting expert Andrew Lokenauth, who started his career at Goldman Sachs. “You should not be carrying a balance or missing payment,” says Lokenauth. “When you carry a balance or miss payments, you can end up paying hundreds to thousands in fees and interest [that] compounds.”
How refinancing or consolidating a personal loan can affect your credit score
Both refinancing and consolidating personal loan debt involves applying for a new personal loan (and using the new proceeds to pay off your old debt). As noted above, when you take out a new loan, this can lead to hard inquiries that can harm your credit score but can also help improve your credit score by increasing your credit mix.
By increasing your amount of available credit, you also stand to improve your credit score. On the flip side, you can also hurt your credit score if you use up too much of that available credit.
Because refinancing a personal loan involves paying off the old loan or loans with the new one, your credit utilization ratio isn’t likely to be affected much. Your average age of credit will be affected, however, because you closed an old credit account or multiple accounts and opened a new one.
All of these moving parts are why it can be so helpful to learn more about what makes up your credit score, so you can understand the implications of opening and closing credit accounts.
“Refinancing and consolidating debt is a must if you can do so at lower rates,” says Lokenauth. “It’s always smart to refinance if you can get a lower interest rate than the one you have on the original loan—you can save thousands of dollars in interest over the life of the loan.”
No matter your stage of borrowing, consider top-rated personal loan companies reviewed by Sound Dollar.