A personal loan can affect your credit score in a number of ways—both good and bad. Taking out a personal loan is not bad for your credit score in and of itself. But it may affect your overall score for the short term and make it more difficult for you to obtain additional credit before that new loan is paid back.
On the other hand, paying off a personal loan in a timely manner should boost your overall score.
- Taking out a personal loan can affect your credit score in a number of ways.
- Your overall credit rating could be lowered temporarily when you take a personal loan because you have acquired additional debt.
- But repaying the loan on time will not only bring your credit score back up, it can also help build it over time.
- In the short term, you may not be able to get another loan or open another credit card.
What Factors Into Your Credit Score
To understand how taking out a personal loan affects your credit score, you must know how the score is calculated. The most widely used credit score by lenders is FICO, which was created by the Fair Isaac Corporation. FICO scores range between 300 and 850.
The scores are calculated based on five factors: payment history, amounts owed, length of credit history, new credit, and credit mix. The exact percentages may vary among the three major credit rating agencies, but here is a breakdown of how much weight each factor has in the calculation, according to FICO:
- About 35% is based on your payment history
- 30% is based on the total amount of your outstanding debt
- 15% is based on the length of your credit history
- 10% is based on any new debt or newly-opened line of credit
- 10% is based on credit mix—the number of credit lines that you have open (including credit cards)
The three major credit reporting bureaus in the United States that lenders turn to—Equifax, Experian, and TransUnion—provide similar scores on your creditworthiness, but there can be small differences.
Does Applying for Loans Affect Your Credit Score?
As you can see, obtaining a new personal loan could affect your credit rating. Your outstanding debt has increased, and you have acquired new debt.
The credit agencies take note of new financial activity. If, for example, you tried to arrange for a new car loan shortly after taking out a personal loan, your application for a car loan might be rejected on the basis that you already have as much debt as you can handle.
Your overall credit history has more impact on your credit score than a single new loan. If you have a long history of managing debt and making timely payments, the impact on your credit score from a new loan is likely to be lessened. The easiest and best way to keep a personal loan from lowering your credit score is to make your payments on time and within the terms of the loan agreement.
How a Personal Loan Can Boost Your Credit Score
A personal loan that you repay in a timely fashion can have a positive effect on your credit score, as it demonstrates that you can handle debt responsibly.
Perversely, people who are most averse to taking on debt could have lousy credit scores. A person who never acquires debt and pays it off in installments has no payment history.
You can receive a free copy of your credit reports from the three credit bureaus every 12 months, which you can obtain by visiting www.annualcreditreport.com.
What Credit Score Is Needed for a Personal Loan?
As mentioned earlier, credit scores range between 300 and 850. The higher your credit score, the more likely a lender is to approve your loan application and offer more favorable terms, such as a lower interest rate. While each has its own criteria, in general lenders view scores above 670 as an indication that a borrower is creditworthy.
FICO scores fall into five categories—poor, fair, good, very good, and exceptional. Here is a breakdown of the ranges:
- Poor (<580): Below average and lenders will consider you a risky borrower
- Fair (580-669): Below average, but many lenders may still approve loans with this score
- Good (670-739): Near or slightly above average and most lenders view this as a good score
- Very Good (740-799): Above average and shows lenders that you are a very dependable borrower
- Exceptional (800+): Well above average and lenders will view you as an exceptional borrower
Most Americans (67%) have a credit score of good or better, according to Experian, one of the credit rating agencies. Only 21% have an exceptional rating.
Also keep in mind that while your credit score plays a crucial role in helping you qualify for a personal loan, lenders also consider other factors such as the amount of income you earn, how much money you have in the bank, and how long you have been employed.
The Bottom Line
A personal loan will cause a slight hit to your credit score in the short term, but making payments on time will boost it back up and and can help build your credit. The key is repaying the loan on time. Your credit score will be hurt if you pay late or default on the loan. And don't forget that a personal loan may also reduce your borrowing power for other lines of credit.