Will taking out a personal loan improve or damage your credit score?
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You may have heard that applying for new loans or credit accounts can hurt your credit score. There’s some truth to that. However, like most personal finance issues, there’s more to the story.
Personal loans can have some negative impacts on your credit score, but they can be positive catalysts as well.
With that in mind, here’s a quick overview of how the FICO credit scoring formula works. Then we’ll look at the potential effects -- both negative and positive -- of applying for a personal loan.
How your FICO Score works
Before we dive into how a personal loan can impact your credit score, it’s important to have a basic understanding of where your credit score comes from. The FICO Score is the most widely used model by lenders. It’s made up of five categories of information.
- Payment history (35%): The top-weighted category that makes up your FICO Score is your history of paying your bills. Paying your bills on time every month has a major positive effect on your credit score. Because this is such an important category, not paying your bills on time can have a devastating impact on your credit score.
- Amounts you owe (30%): The amounts of your debts are a close second in terms of importance to your FICO Score. However, this doesn’t refer to the actual dollar amounts you owe. Your balances relative to your credit limits or original loan balances are more important.
- Length of credit history (15%): Longer and more established credit histories are more favorable. This makes sense -- someone who has paid all of their bills on time for 10 years is less of a credit risk than someone who has paid all their bills for one year.
- New credit (10%): This includes recently opened accounts as well as recent credit applications (also known as inquiries). The idea is that applying for lots of new credit could be a sign of financial trouble.
- Credit mix (10%): This category matters more when your credit history is short and there isn’t much other information to go on. Lenders want to know that you can be responsible with different types of credit accounts (mortgage, auto loan, credit cards, etc.), not just one or two.
Potential negative impacts from taking out a personal loan
With the FICO information categories in mind, let’s go over the potential negative impacts of taking out a personal loan.
When you first take out a personal loan, your application shows up as a credit inquiry and the loan account as a form of new credit. So the new credit portion of your FICO Score could take a hit.
Most personal lenders allow you to check your rates and loan terms for a personal loan without impacting your credit score. So shop around. I encourage you to pre-qualify with several personal lenders in order to compare your options.
Once you proceed past the pre-qualification stage and fill out a lender’s application, it will trigger a hard credit pull. This shows up on your credit report and can impact the new credit portion of your score for one year.
Unless you’ve opened several new credit accounts in the past few months or have been applying for all sorts of credit, this impact should be small. A single credit inquiry or new account is unlikely to drop your score by more than a few points. You’re only likely to see a large impact if you’re adding the personal loan to several other new credit items.
Another potential negative effect occurs in the “amounts owed” category. When you first open your personal loan account, you still owe 100% of the original balance. This is nowhere near as bad as maxing out a credit card account. But it could still cause your score to take a moderate hit.
Positive effects should outweigh negative over time
You may have noticed that the potential negative effects of taking out a personal loan are immediate. On the other hand, most of the long-term effects of a personal loan are positive.
As you make your loan payments over time, you’ll establish a strong payment history. That can boost the most important category of FICO scoring information.
Another effect of making your payments is that your loan balance will steadily decline, helping you in the “amounts owed” category. These two categories combine for 65% of your FICO Score, so it’s fair to say that they outweigh the “new credit” negative impact.
It’s also worth noting that installment debt is generally better than revolving debt like credit cards. Owing 80% of your original balance on a personal loan is better than using 80% of your available credit on a credit card.
If you take out a personal loan to consolidate credit card debt or another type of revolving debt, the shifting of your debt from revolving to installment can have a huge positive impact. Not only will you replace your revolving debt with installment debt, but you’ll now have credit accounts with little or no balances.
When I took out a personal loan a couple years ago to repay credit card debt from furnishing my new home, that’s exactly what happened to me.
Finally, if you have a short credit history, adding a personal loan can help you in the “credit mix” category, especially if you don’t have any other types of installment debt on your credit report.
The bottom line: What to expect when you take out a personal loan
Every situation is different, and the exact FICO formula is a well-guarded secret. Additionally, there are a variety of possible personal loan amounts and terms you could get. There’s no way to predict the exact impact on your credit score when you take out a personal loan.
The most common scenario, assuming you make your loan payments on time, involves a small drop in your credit score after applying for and obtaining a personal loan. It’s usually less than 10 points. A gradual and noticeable positive shift will probably occur in the months that follow. If you use your personal loan to pay off credit cards, the positive impact can be much faster.
To sum it up, a personal loan is likely to cause a barely noticeable drop in your credit score at first. But, over the long run, you’ll see strong positive effects.
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