How personal loans affect credit scores

Personal loans can be a great solution to high-interest debts or surprise expenses, but take the time to learn how they can affect your credit score. (iStock)

Personal loans can be great options for refinancing high-interest debt or covering unexpected expenses. But you might find yourself asking: How does a personal loan affect my credit score?

A personal loan can impact your credit score in multiple ways, including when you apply, borrow and begin to repay the debt — let’s take a look at how.

• What is a personal loan?
• How a personal loan can positively affect your score
• How a personal loan can negatively affect your score
• What you can do to control the impact
• Is a personal loan right for you? 
• How to get a personal loan
• What are some alternatives to personal loans?

What is a personal loan?

A personal loan is a general-purpose consumer loan. Unlike a mortgage, a car loan or a student loan, you can use a personal loan for any purpose, such as consolidating debt or paying off large, one-time expenses, like a medical bill. 

Mortgages and car loans also differ from personal loans in that they’re secured loans — meaning the home or car you buy with the loan is collateral and can be seized if you don’t make your payments. Personal loans are usually unsecured and lenders will use your credit score and income level to determine if they’ll lend to you, how much they’ll lend to you, and at what interest rate. Secured personal loans are an option if you don’t have the credit or cosigner to qualify for a typically safer-to-borrow unsecured loan.

You can easily compare personal loan rates from top lenders in minutes with Credible.

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 credit 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: 

• 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

To a large degree, how a personal loan affects your credit score is under your control. Here are some strategies you can use to ensure that any personal loan you take out benefits you in the long run:

• Check your credit score. Go to AnnualCreditReport.com and pull your credit reports for free. You can get free copies from each of the three main credit bureaus (Equifax, Experian and TransUnion) every week through the end of 2023. Make sure all the information in your reports is correct and contest any errors, especially if it dings your credit score. The better your credit score, the more likely it is that you’ll qualify for great interest rates and get the full loan amount you need.
• Do your research. The additional fees and high interest rates of some personal loans can be a negative outcome. Rate shop with banks, credit unions and online lenders to find the lowest interest rates and fewest fees. It’s often easy to get quotes from lenders online these days, so there’s no excuse not to compare and see which option will save you the most money.
• Don’t get in over your head. One of the biggest mistakes you can make is taking out a loan you can’t afford to repay. Run the numbers and make sure that the monthly payments fit into your budget.
• Set up autopay. Missing, late or incomplete payments can lower your credit score. Set up autopay or a monthly reminder to ensure that you don’t forget a payment.

Is a personal loan right for you?

Determining whether a personal loan is a good choice for you will depend on your unique financial situation. Here are some scenarios when a personal loan may be the best choice:

• You’re going to use it to pay off high-interest debt. While the interest rates and fees associated with a personal loan can add up, they’re often lower than the interest rates and fees on credit cards. Consolidating your credit card debt or other high-interest debt with a personal loan can save you money in the long run. An important note: If you do pay off a credit card with a personal loan, make sure you change your habits so you don’t just run up a big balance on your credit card again. Otherwise, you’ll end up with a high-interest credit card bill and a personal loan balance you’re paying off each month, which can trap you in a cycle of debt.
• You have a great credit score (or cosigner). If you have excellent credit, personal loans typically come with low interest rates and minimal fees — and you also likely have a track record of making smart financial decisions. That means you already have good financial habits in place to pay off the loan on time. If your credit could use improvement, however, you could still access attractive terms by considering cosigned personal loans.
• You know you can use it responsibly. You should try to avoid a personal loan to go shopping or take a vacation — but it can be a good idea to take out a personal loan for a home improvement project. The difference? Improving your home can add value to it and protect your investment, while a designer purse or a European vacation won’t improve your financial position or your life in the long run.

If you’ve determined that a personal loan is right for you, visit Credible to compare personal loan rates from multiple lenders without affecting your credit score.

How to get a personal loan

Here’s how you can get a personal loan in five simple steps:

1. Check and improve your credit score. You can get free credit reports each week through the end of 2023. Check your reports for inaccuracies. Your credit score will be perhaps the biggest factor in determining your interest rate, so it can be worth it to take some time to boost your credit score before you apply for loans.
2. Determine the amount you need. Sit down and calculate exactly how much money you need to borrow. Lenders may charge fees that come out of the total amount — like an origination fee for processing your loan application — so factor that in. Then use a personal loan calculator to estimate what your monthly payments will look like and make sure that they fit in your budget.
3. Shop for the best loan. Compare loan options from online lenders, banks, and credit unions. You can often prequalify and check rates for loans with a soft credit check that won’t impact your credit score. Compare APRs (interest rates that account for fees), loan amounts and loan terms to determine what’s right for you. After you decide which loan is best for you, apply for it and await approval. These days, most loan applications are streamlined and won’t take much time. You’ll need to prove your identity, verify your address and supply proof of income. The lender will also run a hard credit check.
4. Pay attention to the details. Once you get approval, read the fine print in the loan agreement closely. Make sure you understand all of the details before you sign.
5. Accept the loan. After you sign the loan agreement, the lender will disburse the loan. Personal loans are typically deposited directly into your checking account within a few days. Once you have the funds, you can get started on your monthly payments.

What are some alternatives to personal loans?

If you can’t qualify for a personal loan or are wisely considering other options, here are some alternatives you can look into:

• Credit card: Some credit cards offer balance transfers with a 0% APR for a certain period of time. While you’ll likely pay a fee for the transfer, these can be a great option for consolidating high-interest credit card debt. Similarly, you can cover most major expenses via a credit card with a 0% APR introductory rate. In any case, make a plan to pay off the balance before the introductory interest rate ends.
• Line of credit: A personal line of credit works similarly to a credit card — you borrow against a set credit line, and the payoff schedule and amount varies based on how you use it. Interest rates are usually better than they are for credit cards, but many lenders charge monthly fees that can offset the savings. If you have a lot of equity in your home, you could also explore a home equity line of credit. It works on the same principle but is backed by your home, which has the positive of usually lower interest rates than a personal line of credit. On the negative side, your home can be seized as collateral if you don’t make your payments.
• Person-to-person loans: Whether you use a lending marketplace where you take a loan from individual investors (LendingClub is a popular peer-to-peer lender) or borrow from a friend or family member, this is a good option if you’re struggling to qualify with a traditional lender. Marketplace lending can sometimes be more forgiving of bad credit scores, but expect high interest rates. Borrowing from someone you know may seem like a great way to dodge the costs and stress of personal loans, but make sure you fully agree on the terms of the loan, such as how long you have to pay it back and if they expect interest of any kind. Then put it in writing. If you default on this kind of loan, you might not get a ding on your credit score, but you can permanently damage close relationships, so proceed with caution.
• 401(k) loan: Many 401(k) plan providers offer this option, and they aren’t credit-dependent like a personal loan. While this can help you deal with a surprise expense or pay off a credit card, it could set your retirement savings back significantly — you’ll miss out on the earnings and tax benefits of a tax-advantaged account.