How does taking out a personal loan affect your credit score?
Personal loan use has been growing in the US, most commonly to consolidate debt or refinance credit cards. But what are the pros and cons for credit scores?
Over the past decade, personal loan use has grown in the United States going from less than $56 billion to $232 billion in the second quarter of 2023. Just in the past year the amount that Americans owe in personal loan debt has jumped 21.5% according to industry data.
A personal loan can be a handy way to pay for a bigger expense that you don’t have cash on hand for at the moment without putting it on a credit card. The line of credit also generally comes with a lower interest rate than if you used a credit card. In the US, personal loans are most commonly used nowadays to consolidate debt or refinance credit cards. But what are the pros and cons when it comes to credit scores?
How does taking out a personal loan affect your credit score?
A personal loan can both help and hurt your credit score. But if you use it responsibly the long-term benefits should outweigh the short-term harm.
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Negative impacts on credit scores of personal loans
When you take out any new line of credit the financial institution you are applying to will run a hard inquiry on your credit. This includes signing up for a new credit card. The request will cause a temporary dip in your credit score of around five points.
It stays on your record for roughly two years, so too many requests in a short amount of time can adversely affect your credit score. As well it may seem to lenders that you are a spendthrift and may have trouble paying your bills.
The new line of credit will also shorten the average age of your credit, the degree to which it could harm your credit score will depend on your credit history. And while a personal loan could be a good way to consolidate debt or refinance credit card debt, lowering the interest rate you pay, failure to make timely payments will drive your credit score down.
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Positive impacts on credit scores of personal loans
A personal loan in the long run could help your credit score in several ways.
A personal loan, especially for those who are trying to develop a credit history, may help you to diversify your credit mix demonstrating to lenders that you can manage multiple types of credit.
Using one to get out from under burdensome credit card payments by consolidating and refinancing them, you can develop an on-time payment record. However, you must have an action plan to avoid falling into a debt cycle.
Using one to pay off your credit cards could also help you reduce your credit utilization rate boosting your credit score. Unlike credit cards, which are a type of revolving credit, that factor into your credit utilization rate, personal loans are an installment loan and do not.
Personal loans typically have a term between one and five years. So over time a personal loan could help with the average age factor of your credit history. Even though once it’s paid off it won’t grow older, its age upon closure will still be included.