A personal loan can influence your credit in a variety of ways. Some ways can be harmful to your credit, whereas others can be beneficial to it. For instance, taking out a personal loan doesn’t hurt your credit on its own. However, it could affect your overall score in the short term and make it harder for you to get additional credit before you’ve paid the new loan back. That being said, if you pay off a personal loan promptly, it can increase your overall credit score.
It doesn’t matter whether you compare online loans or compare loans from traditional lenders, taking out a personal loan will affect your credit score. To better understand the impact a personal loan may have on your credit, let’s examine what factors go into making up your score and how applying for a loan affects your score.
Components That Make Up Your Credit Score
To understand whether taking out a personal loan hurts your credit, you first must understand how a credit score is calculated. The credit score system most commonly used by lenders is FICO. FICO scores range between 300 and 850.
FICO scores are calculated based on five components: amounts owed, payment history, length of credit history, new credit, and credit mix. FICO gives each factor the following weight in their calculation of your credit score:
- Your payment history decides approximately 35% of the score.
- Your total amount of outstanding debt determines 30% of your credit score.
- The length of your credit history determines 15% of your score.
- How much new debt or newly opened line of credit you have defines 10% of your credit.
- How many credit lines you have open (including secured credit cards) determine 10% of your score.
How Applying for a Loan Impacts Your Credit Score
If we look at the components that make up your credit score, we can see that two factors that affect your score are new debt and the amount of outstanding debt. When you take out a personal loan, your credit score is negatively affected by both these factors. However, your overall credit history has more impact on your credit score than a single new loan. If you have a lengthy history of managing debt and making payments on time, the effect on your credit score will be lower.
While initially, taking out a personal loan may lower your credit score, if you repay your loan on time, it can have a positive effect on your credit score. This is because it shows that you can handle debt responsibly.
Another way that applying for a loan may impact your credit score is during the application process. A lender will generally trigger a hard credit check when you apply for a personal loan. This inquiry usually takes five points off your FICO credit score.
Summary
A personal loan will affect your credit score both negatively and positively. When you take out a loan, you add new debt and increase your outstanding debt amount, which lowers your score. Furthermore, when you apply for a loan, a lender does a hard check, reducing your score by five points. However, if you pay your loan in a timely manner, this will increase your credit score.
