Can a personal loan improve your credit score? In many cases, yes. A personal loan can help you:
However, shopping for a personal loan can temporarily lower your FICO scores. It's important to know how to shop for and use a personal loan wisely to raise your credit score.
What Is a Personal Loan?
Personal loans are installment loans, which means you borrow a lump sum and repay it over a specified number of years or months.
Personal loans have common characteristics that can help you boost your credit score:
- They usually have a fixed interest rate and payment.
That makes budgeting and paying on time easier - and every on-time payment moves you closer to a great credit score.
Credit bureaus consider installment loans as better than credit cards because high credit card debt is a good predictor of future financial difficulty. On the other hand, having a personal loan, a car loan, student loan or a mortgage doesn't usually indicate overspending.
How a Personal Loan Can Improve Your Credit History
The personal loan's advantage is that it is simple. You know what your loan balance is, what your payment is, when it's due and exactly how long it will take to pay the balance off. Just make your monthly payments on time and let good payment history improve your credit score every month.
Personal loan providers often specialize in certain types of customers. There are lenders that approve personal loans with low or no credit scores. If your credit score is not good, those are the lenders you'll approach.
What if you can't get approved for a personal loan?
If you can't get approved for a personal loan, you can establish good credit with a secured credit card.
It's not really a credit card because you put money on deposit with the card issuer. But if you choose one that reports to all major credit bureaus and has reasonable fees, you can build credit history. And many of these cards eventually increase your credit limit or return your deposit to you after you establish a good track record with them.
How a Personal Loan Can Enhance Your Mix of Credit
There are several factors that make up a credit score:
- Credit history
- Amounts owed
- Type of credit (credit mix)
- Age of accounts
- New credit / inquiries.
According to Experian, one of the three major credit bureaus:
"Credit scoring models - the statistical algorithms that distill the contents of your credit report into three-digit scores - generally favor credit histories with a variety of loan types. More specifically, a blend of installment debt and revolving debt can benefit your credit scores."
If credit card debt dominates your credit report, adding an installment loan improves your credit mix and can raise your FICO score.
How a Personal Loan Can Improve Your Credit Utilization Ratio
Many consumers take out personal loans to consolidate debt, and for good reason. Not only are credit card interest rates usually higher than personal loan interest rates; replacing credit card debt with installment debt can really improve your credit score.
That's because the percentage of revolving credit that you're using, which is called "credit utilization," makes up 30% of your credit score. The only factor that's more important is your repayment history. If you have four credit cards with a total limit of $8,000 and your balances total $4,000, your credit utilization is 50%. That's very high.
Paying off a credit card with a personal loan restores the entire line of credit. Consolidating all of your credit card debt with a personal loan can reduce your credit utilization ratio to zero.
Because you can drop your credit utilization ratio drastically and quickly, and because utilization comprises such a large part of your FICO score, this method is one of the fastest ways to raise your credit score.
Debt Consolidation Pitfalls
However, personal finance specialists don't recommend debt consolidation for everyone. Mistakes can harm your financial security and wreck your credit, so learn before you leap.
- Not understanding how debt consolidation works
Debt consolidation does not magically make debt disappear. You still owe the money.
- Not changing your spending habits
If you cannot help overspending and carrying credit card balances, don't consolidate debt with a personal loan. You'll run up your credit cards again and have those payments plus the personal loan payment. You'd be better off with credit counseling and a debt management plan.
- Not recognizing your payment may increase with a personal loan
Consolidating debt can increase your monthly payment even with a lower interest rate. That's because many credit card companies set minimum payments low enough to keep you in debt for decades. A personal loan payment might be higher, but you know exactly when you'll be debt-free. Just make sure that the payment is affordable.
- Not keeping credit cards open after you consolidate your debt
If you consolidate your credit card debt and close your accounts to keep from using them, your credit utilization won't improve. If your spending is that much out of control, closing the accounts might still be a smart move, but your credit score won't benefit much and could even fall slightly.
Personal loans - not the only way to consolidate debt
Debt management plans from non-profit credit counselors can be helpful to those who are not managing their debt well.
If you have enough discipline, a zero-interest balance transfer card could give you six to 24 months of no-interest financing, allowing all of your payment to go toward debt reduction.
There's a fee to transfer your balances, usually 3%, but you can save a lot of money if you're able to clear the debt before the zero-interest period expires.
Debt consolidation with a personal loan is the right choice for many consumers. Just make sure that you shop for the lowest rate for which you qualify, that you can afford the fixed monthly payment, and that you won't resume carrying credit card balances after paying them off.
Personal Loan Inquiries Can Drop Your Credit Score
Credit scoring models treat all inquiries as negative because inquiries mean that you are planning to take on more debt.
Additional debt can increase your risk for financial difficulty. FICO, the company that created the most widely used credit scoring systems, says that consumers with six or more inquiries on their credit reports can be up to eight times more likely to declare bankruptcy than those with none.
However, most consumers don't buy multiple homes or cars at the same time, so all inquiries for home or auto financing made within a short period of time (14 to 45 days depending on the version) are treated as one. That's not the case with credit cards or personal loans.
How major credit bureaus treat personal loan inquiries
It's important to understand how the major credit bureaus (Experian, TransUnion, and Equifax) treat inquiries from personal loan providers. It's different from the way their scoring models consider inquiries for mortgages or auto loans.
Every time a personal loan provider pulls your credit, the inquiries cause a small drop in your credit score (five points or fewer). But it might not take many credit pulls to drop you from a desirable applicant (say, with a FICO over 700) to a just-okay applicant with a score of 679.
So when shopping for a personal loan, you might want to check your credit at annualcreditreport.com for free. It's the credit reporting site maintained by the federal government.
Make sure that the information on your report is accurate. You can purchase your scores for a small fee and just tell lenders what your scores are when you ask for interest rate quotes.
Note that the credit score drop from inquiries is temporary. It does not drop your credit score when you check your own credit.
New Accounts Can Drop Your Credit Score
Another factor in credit scoring is the average age of your accounts. Taking out a personal loan can affect this factor in a couple of ways.
First, adding a new account will reduce the average age of your accounts. That's just math, and there's not much you can do about that.
Second, if you use a personal loan to consolidate debt, you might think it's a good idea to close the zeroed-out credit cards so you're not tempted to use them again. That's understandable. But if you close out long-standing accounts while also opening up a brand-new one, you could substantially impact the average of your accounts.
Weighing the Benefits of a Personal Loan
A personal loan can be most helpful to your credit score if your credit utilization is high. It can also be useful if your mix of credit consists mainly of revolving accounts like credit cards, or if you need to build or rebuild a good repayment history.
The ideal candidate is probably a consumer with high credit balances on fairly new accounts. In that case, there is little to be lost by replacing them with a new installment account.
Shopping for a personal loan generates inquiries, and lowering the average age of accounts can also knock some points from your FICO score. This can temporarily affect your credit score in a negative way.
However, the benefits of a good repayment history, the addition of installment debt to your credit mix and the reduction in credit utilization will usually outstrip the temporary dip in your FICO score.