A personal loan is a common way to consolidate debt and pay for unexpected expenses. It’s essential, however, to adequately understand how this decision can affect your credit score, both in positive and negative ways. Anytime you apply for new credit, your credit score will likely change.

Here are four ways a personal loan will impact your credit score and history.

1. Hard Inquiries for Loan Application

When you submit an application for a personal loan, whether it is a secured or unsecured loan, the creditor will perform a hard inquiry on your credit report. The inquiry can temporarily lower your credit score by a few points, and it will stay on your credit report for approximately two years. However, a dip in credit score due to a hard inquiry is normally short-lived, and your credit score bounces back within a few months after the request.

While a single hard inquiry may only decrease your credit score by a few points, multiple inquiries in a short period can be a red flag and lower your credit score even more. The assumption is that you are desperate for additional financing and struggling with your current debt burden.

2. Diversification of Credit Mix

One factor that slightly impacts your FICO score is your credit mix, which accounts for around 10% of your credit score. Lenders and credit scoring models prefer to see that you have a history of using different types of credit, including credit cards, personal loans, auto loans, home mortgages, and student loans.

By taking out a personal loan, you’re adding an installment loan to your credit profile, which can improve your score if you only have a history of using credit cards and other types of debt. Adding a personal loan and making timely payments over the term of the loan can actually increase your credit score.

3. Building a Positive Payment History

According to Experian, your credit score is impacted by the following five factors. Each factor is weighted differently when calculating your credit score, as some factors are deemed more important than others.

  • Payment History: 35%
  • Amount of Debt Owed: 30%
  • Length of Credit History: 15%
  • Credit Mix: 10%
  • New Credit Inquiries: 10%

Notice how your payment history is the most significant factor in your credit score, making up 35% of your FICO score. By consistently making on-time payments, you show lenders that you are a responsible borrower. Over time, a history of timely payments can significantly improve your credit score. A personal loan provides you an opportunity to build a strong payment record.

4. Lowering Your Credit Utilization Ratio

Using a personal loan to consolidate high-interest credit card debts can improve your credit utilization ratio and ultimately increase your credit score. A credit utilization ratio is the percentage of available credit you’re using. Generally, a lower ratio is a better signal of creditworthiness to lenders.

For example, assume you have three separate credit cards with a $10,000 credit limit on each card, so your total available credit is $30,000. Your open balance on each card is $1,500, so your total credit card debt is $4,500 (i.e., $1,500 times 3). Based on these figures, your credit utilization ratio is 15% (i.e., $4,500 / $30,000).

Credit utilization accounts for about 30% of your credit score, so if you pay off credit card balances with a personal loan and keep those credit cards open, your overall utilization decreases, which can boost your credit score.

Final Thoughts

Applying for a personal loan can have both a positive and negative impact on yoru FICO score. By making on-time payments, diversifying your credit mix, and lowering your credit utilization ratio, a personal loan can help improve your credit score over time. However, hard inquiries, taking on too much debt, and missed payments can hurt your credit if not handled responsibly.

Before applying for a personal loan, you should carefully assess your current financial situation and ensure that you can afford the monthly payments. Remember, the interest rates on personal loans are substantially higher than other forms of debt, and the repayment schedules are quite fast.

A personal loan can be a valuable tool for improving your credit, but poor financial decisions can wreak havoc on your credit.