Key Takeaways:
- A personal loan can give you quick access to money, helping you handle big expenses or emergencies without draining your savings, but make sure you understand how it could affect your credit score before applying.
- After issuance, personal loans may help your credit profile by diversifying your credit mix, lowering your credit utilization and improving your credit health if you make timely payments.
- On the other hand, personal loans can hurt your credit score due to a hard inquiry at application, increase your debt, reduce account age and harm your credit health if you miss payments.
- Once the loan is issued, its impact on your credit score depends on how you manage the loan.
- Before applying, consider rates and terms, the amount of debt you can afford, your current credit health and the potential fees involved with the loan.
Disclosure:
This post only contains educational information. No financial, tax or legal advice.
This information is for educational purposes only and we do not guarantee the accuracy or completeness of this information. This information does not constitute financial, tax or legal advice and you should consult your own professional adviser regarding your situation. This website may contain links to third party websites. We are not responsible for their content or data collection. Trademarks used in this material are property of their respective owners and no affiliation or endorsement is implied.
Thinking about getting a personal loan It can be a smart way to manage your money—whether you're consolidating debt, covering an emergency, or making a big purchase. But before you apply, it's important to understand how a personal loan might affect your credit score, covering an emergency, or making a big purchase.
Your credit score plays a big role in your financial health. It can influence whether you’re approved for loans, the interest rates you pay, and even your ability to rent an apartment. A personal loan can impact that score in both positive and negative ways, depending on how you manage it.
In this article, we’ll break down what a personal loan is, how it works, the ways it can impact your credit (both good and bad), and what to consider before applying and signing on the dotted line. Plus, we’ll share tips to help you use a loan to build stronger credit over time.
What is a personal loan and how is it used?
A personal loan is a financial product provided by banks, credit unions or online lenders. It gives you a lump sum of money that you repay over time - usually in fixed monthly payments with interest.
Personal loans are a type of installment loan, meaning you borrow a set amount and repay it over a specific period. In general, most come with fixed interest rates and repayment terms, in which case your monthly payment stays the same. (If you do get a personal loan with a variable rate, then your monthly payments can fluctuate).
This is different than credit cards, which offer revolving credit which lets you borrow, repay, and borrow money again, often with no set payoff schedule. Because personal loans give you a one-time lump sum, they’re great for larger, one-time expenses like home fixes, car repairs, medical bills or major purchases.
Common uses for personal loans
What makes personal loans especially appealing is their versatility. You can use them for many different needs that could include:
- Consolidating high-interest debt
- Making home improvements
- Covering unexpected expenses
- Paying for weddings or vacation
- Financing other personal needs
Because of this flexibility, personal loans can be a practical solution for managing both planned and unplanned expenses.
Personal loans are usually unsecured
Unlike secured loans, such as mortgages or car loans, that require something valuable (like a home or an automobile) as collateral that allows the lender to repossess or claim the asset if the borrower defaults, , personal loans do not. Personal loans are typically unsecured. This means you don’t have to offer anything as a guarantee to get the loan. This means you don’t have to offer anything as a guarantee to get the loan.
Lenders mainly rely on the borrower’s creditworthiness and financial situation to gauge risk to decide if you qualify.
Applying for a personal loan basics
Obtaining a personal loan will involve an application process. Once you’ve found a personal loan that feels right for you, complete a loan application. Here are the steps that you’ll likely need to follow:
- Visit the chosen lender’s website or branch. Find where to start the application.
- Fill out the application form. Have your social security number, proof of income (like W2 or bank statements), loan amount, purpose and how long you want to repay it.
- Review the application and submit it.
- Wait for the lender’s approval decision.
Because personal loans don’t require an asset like a house or car to back them up, there’s no need for things like appraisals or inspections. Because of that, personal loans can be more readily accessible with a simpler, faster approval process than loans that are secured by collateral.
How can a personal loan help your credit?
A personal loan might actually help improve your credit profile. But it very much depends on how you manage it. Below, we explain how a personal loan could impact your credit score.
Credit score factors personal loans can help
-
Payment history
On-time payments can demonstrate financial responsibility.
-
Credit mix
You can diversify your credit mix and show lenders you can handle multiple loans.
-
Utilization
Consolidating debt can reduce your credit utilization.
Can build a positive credit history
Your payment history is a crucial credit score factor. Every on-time payment you make on your personal loan adds to a positive track record.
Pro Tip:
Before getting a personal loan, make sure it’s truly affordable for your budget. If you miss payments, it can hurt your credit, lead to late fees or even result in collections. Always review the loan terms carefully and be honest with yourself about whether you can make the monthly payments consistently—without stretching your finances too thin.
Can diversify your credit mix
Credit scoring models reward diversity in your accounts. If you primarily have revolving credit (like credit cards), adding an installment loan such as a personal loan can enhance your credit mix.
Can lower credit utilization ratio
Credit utilization measures how much of your revolving credit (like credit cards) you are using of your available credit limit, expressed as a percentage.
What is Credit Utilization Ratio?
Credit utilization ratio is the percentage of your available revolving credit that you’re using. Formula: (Credit you’re using ÷ Total credit limit) × 100 = Credit Utilization Ratio.
Here’s where a personal loan comes in:
- If you use a personal loan to pay off credit card balances, your revolving debt decreases, which lowers your utilization ratio.
- For example, if you have $5,000 in credit card debt and $10,000 in available credit, your utilization is 50%. Paying off that debt with a personal loan drops your utilization to 0%, which can positively impact your score.
So, with the strategy outlined above, when you use a personal loan to pay off your credit card balances, your credit card debt goes down.
Remember, credit utilization only applies to revolving accounts, not installment loans like personal loans. While the loan itself doesn’t count toward utilization, using it to pay down credit cards can indirectly improve this factor.
How can a personal loan hurt your credit?
Personal loans can be a useful financial tool, but like any form of credit, they can also influence your credit score in both positive and negative ways. Understanding how personal loans interact with the key components of your credit score can help you make smarter borrowing decisions and avoid unintended consequences.
Can lower your score through missed payments
Payment history is a big part of your score, so even one missed payment can cause damage. Failing to meet payment requirements or defaulting can result in a lowered credit score.
Pro Tip:
Timely payments are crucial for maintaining a positive payment history. To help with this, consider setting up automatic payments with your bank so you can stay on schedule.
Adds a hard inquiry to your report
The application process will result in a hard inquiry temporarily lowering your score. This hard inquiry typically stays on your credit report for up to two years.
To help reduce the impact that this hard inquiry has on your credit score, consider bunching your applications around a relatively short window (about 14 days) as you rate shop and avoid applying for too many loans at once.
Increases your debt
When you take out a personal loan, your total debt rises. While installment loans like personal loans don’t count towards credit utilization, your total overall balances still matters. High balances can signal too much debt burden, which may be an indicator of potential difficulty making payments in the future and can lead to a lowered score.
There’s another factor to consider: debt-to-income ratio (DTI). Adding a personal loan increases your monthly obligations, which raises your DTI. While what’s considered “good” varies by lender and loan type, many lenders prefer to see a DTI of 35% or lower when you’re applying for major financing like a mortgage or auto loan. A lower DTI suggests you have enough income to comfortably cover your payments, which can make you a more attractive borrower.
Shortens credit history age
Opening a new personal loan can lower the average age of your credit accounts, which is one factor considered in credit scoring.
The length of your credit history is measured by the average time between your oldest and newest accounts.
Can pay high interest and unexpected fees
Higher costs don’t directly lower your credit score, but they can strain your budget—making it harder to keep up with payments, which can hurt your credit over time.
As discussed earlier, personal loans are typically unsecured loans, meaning they aren’t backed by collateral like a car or home. Because of this, they often come with higher interest rates than secured loans. If your credit score isn’t strong, those rates can climb even higher, which means you could end up paying much more than you originally borrowed.
Beyond interest, personal loans may come with additional costs that may strain your budget, such as origination fees, late payment penalties, and pre-payment penalties all of which can add to your debt level. Failing to plan for these costs can stretch your finances and increase the risk of missed payments—one of the fastest ways to damage your credit score.
What to consider before applying for a personal loan
-
Choose the purpose of the loan to identify the best loan amount and terms.
-
Review the interest fees and compare rates to help you pick a loan.
-
Check your credit health to help land better terms.
-
Know what your debt obligations are to avoid overstretching your finances.
-
Review potential fees to help you better understand your budget.
Considerations before applying
Before you apply for a personal loan, it’s important to ask yourself a few key questions. This can help you make a smart decision and avoid problems later.
Before applying:
- Choose the purpose of the loan: Clearly define the purpose of the personal loan. Whether it's debt consolidation, home improvement or covering unexpected expenses, having a specific goal will help you choose the loan amount and terms that work best for you.
- Review the interest fees and terms: Understand the interest rates and any additional fees associated with the loan. Compare rates from different lenders to find the most favorable terms.
- Check your credit health: A higher credit score can help you qualify for lower interest rates on a personal loan. To keep your score in good shape, check your credit report regularly and look for errors that could hurt your score. If you find a mistake, then you can dispute it. You can check your TransUnion® credit report for free with daily updates available. Or get a credit report from all three major credit bureaus each week at AnnualCreditReport.com.
- Know your debt obligations: Look at your budget. Will you be able to make the loan payments every month without falling behind on other bills Missing payments can hurt your credit and lead to extra fees. Consider meeting with a credit counselor if you need assistance or advice.
- Review potential fees: Some loans have fees for things like applying, paying off the loan early, or making late payments. Read the fine print so you know what to expect.
Monitoring your credit before and after a personal loan
Keeping an eye on your credit could be beneficial when you're thinking about getting a personal loan—and after you've already taken one out.
Before you apply
Monitoring your credit before applying for a personal loan can help you feel more prepared. It gives you a better understanding of your credit score and what’s affecting it, so you know where you stand. You’ll also have a chance to spot and fix any errors on your credit report—like incorrect account details or late payments that don’t belong. These mistakes can affect your loan terms. Improving your credit health ahead of time could mean better rates and lower costs.
After you get the loan
Once you get your loan, credit monitoring remains important. It helps you track your progress by showing how your credit score may change as you make on-time payments, which can be motivating. Monitoring also alerts you to changes on your credit report—like a missed payment or a new account you didn’t open. These alerts can help you act quickly to protect your credit.
TransUnion Credit Monitoring
TransUnion offers free credit monitoring to help you stay on top of your credit.
- Credit updates: Get daily updates for your TransUnion credit report.
- Critical notifications: Get alerts when there are critical changes to your credit report, like new accounts, so you can catch potential problems early.
- Understand your credit: See specific credit goals based on your profile and get personalized suggested actions to consider such as decreasing utilization or raising your credit limit.
Best of all, it’s completely free and doesn’t require a credit card to sign up.
Frequently asked questions
Still curious about how personal loans work? Below are some frequently asked questions about personal loans and how they may affect your credit:
Using a personal loan to pay off credit card debt can be a good financial move if the loan has a lower interest rate than your credit cards. It can help you save money, simplify your payments, and even improve your credit profile by lowering your credit card balances. But this strategy can also hurt your credit if you miss payments, take on more debt, or open a new account that lowers your credit age. It can also cause a temporary dip in your score due to a hard credit check when you apply.
Payment history is a major credit score factor and late or missed payment can negatively impact your credit profile. To help avoid late payments, consider automatic payments or setting payday reminders for yourself.
According to the Consumer Financial Protection Bureau, you should aim to check your credit report for inaccuracies at least once per year. However, note that all 3 credit bureaus, TransUnion, Experian® and Equifax®, offer consumers free weekly credit reports at AnnualCreditReport.com
