A personal loan (like any kind of installment loan) can help your credit score, but it can hurt too. In fact, your personal loan will probably do both.
We’ll get into exactly how that happens in just a moment. But for context, let’s first talk about how credit scores get calculated in the first place.
To determine your credit score, a credit bureau considers several different factors. While all these factors matter, they don’t all get equal weight in your credit score. In other words, some factors matter more than others (as you can see in the graphic below).
Your payment history has the most weight. Have you paid your past credit back on time? Then you should have a good payment history. This includes payments on installment loans (like a personal loan or your mortgage) as well as payments on revolving credit (like credit cards). A better payment history will lead to a higher credit score.
Then you’ve got the amount owed, which you can also think of as your current credit utilization ratio. If you max out all your credit cards, you'll have a very high credit utilization ratio. But if you carry a smaller balance on each, you'll have a better ratio. So if you’re using 95% of the credit available to you, for example, you might end up with a lower credit score than if you’re using around 10%.
The next largest factor is the length of your credit history, or the length of time you’ve had your open credit cards and loans. A longer credit history will boost your score, while a bunch of new accounts will hurt it.
It makes sense, then, that new credit also matters. A hard credit check (also called a credit inquiry, often done when you apply for a new loan or credit card) will hurt you here. So think carefully before you apply for new credit, since it could (temporarily) hurt your score.
And finally, there’s your credit mix. If you have several different kinds of credit (think a mortgage, an auto loan, some credit cards), you’ll end up with a higher score than if you just have one type of credit (like a personal loan).
When you first submit a loan application, expect your personal credit score to take a hit. That’s because your lender will probably do a hard credit check, which―as you recall―negatively affects the new credit portion of your score.
Once you get approved and actually take out the loan, the new credit account may ding your credit history a bit. So while a personal loan may improve your credit mix (depending on what else you have), you shouldn’t be surprised if you see an overall (small) drop.
It gets better from there though. As you make payments over the course of your repayment term, you’ll improve your payment history and the length of your credit history―both things that can help your credit score. Unless, of course, you miss payments, which will hurt your payment history.
And if you decide to refinance your loan for debt consolidation, you may improve your amount owed if you use your new loan to pay off credit card debts. Yes, the new debt consolidation loan might mean a hit to your new credit―but that counts for less than your amount owed.
Altogether, your personal loan should have a net positive effect on your FICO credit score (as long as you keep up with loan payments, that is). You shouldn’t expect excellent credit overnight. But with some patience and time, your credit rating should improve.
