Can Personal Loans Build Credit?: How Personal Loans Affect Your Credit Score
Credit scores can feel mysterious, thanks to secret algorithms and score fluctuations that seem random. But, as it turns out, you can predict how something will affect your credit score.
So if you’re wondering if a personal loan can improve your credit score, we’re happy to tell you that the answer is yes. Except, well, it’s a little more complicated than that. You might even see a dip in your score before you see a boost.
Don’t worry, though. We’ll break it all down for you. In this guide, we’ll explain how a personal loan can change your credit score over time, why it has that effect, and what other things you can do to improve your credit.
How will a personal loan affect your personal credit score?
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.
Credit score factors
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).
Personal loans and your credit
Expected effect on your credit score
|Applying for a personal loan||New credit||Decrease|
|Getting approved for a personal loan||Credit history, credit mix||Decrease|
|Making payments on a personal loan||Payment history, credit history||Increase|
|Missing payments on a personal loan||Payment history||Decrease|
|Refinancing your personal loan||Amount owed, new credit||Increase|
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.
Other ways to build your credit
Now you’ve seen that yes, a personal loan can build your credit (though that may not happen right away). But personal loans are just one of the ways you could build credit.
For example, you can consider taking out one or more of the following types of credit:
- Home mortgage
- Auto loan
- Business or personal credit card
- Business loan or line of credit
- Student loan
- Other loans
These all have the potential to help your credit score―if you make regular on-time payments.
A personal loan won’t be a magic solution to a bad credit score. In fact, when you first get one, your personal credit score might drop a bit. But with each loan payment, you’ll work toward better credit. And in the end, you should find that your personal loan has helped build your personal credit.
So while we don’t advise you to take out a personal loan just to boost your credit (there are plenty of other things that can help with that), you don’t have to worry about a personal loan damaging your credit forever.
Good luck with your loan―and with building good credit!
Now that you’ve learned one way to build personal credit, learn more about how to build business credit.
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