While your credit may suffer initially, the sting is likely to be minor and short lived.Image source: Getty Images.
You may have heard that applying for new credit can hurt your credit score. There’s certainly some truth to that. This is why you’re advised not to apply for any new credit before you close on your home when you apply for a mortgage, and why many lenders advertise that you can check your interest rates “without affecting your credit score.”
Having said that, there’s a lot more to the story. Applying for a personal loan can indeed hurt your credit initially, but the impact is far less painful than many people think. And the long-term effects of having a personal loan on your credit report can greatly outweigh the initial sting of applying for one.
The short answer
First off, everyone’s credit history is different and there are a variety of amounts and terms you can get when it comes to personal loans. This makes it impossible for me to give a one-size-fits-all answer here.
Having said that, the short answer is that a personal loan is likely to cause an immediate, but small, drop in your credit score. When I applied for a personal loan a few years ago, my FICO® Score dropped by 3 to 4 points initially, depending on the credit bureau I was looking at.
What happens after that depends on a few factors, so to answer the question more thoroughly, let’s look at a rundown of how your credit score works to see all of the ways a personal loan could affect you.
How your FICO® Score works
The FICO® Score is the most widely used model by lenders by a wide margin, so we’ll focus on that. The FICO model is made up of five specific categories of information, each of which has its own weight.
- Payment history (35% of FICO® Score) -- The category that has the most impact on your FICO® Score is your history of paying your bills on time (or not). As long as you pay your bills on time every month, this should be a major positive catalyst to your credit score. Conversely, not paying your bills on time can have a devastating impact on your credit score because this category carries so much weight.
- Amounts you owe (30%) -- The amounts you owe to your creditors are a close second in terms of importance to your FICO® Score. However, this doesn’t necessarily refer to the actual dollar amounts you owe. Instead, it focuses more on how much you owe relative to your credit limits and original loan balances.
- Length of credit history (15%) -- In a nutshell, longer is better. From a creditor’s perspective, a borrower who has paid all of their bills on time for 10 years is less of a credit risk than someone who has paid all their bills for one year, even if both have an excellent record.
- New credit (10%) -- This includes recently opened accounts, as well as credit inquiries from the past year. There’s a statistical correlation that shows applying for lots of new credit can be a sign of financial trouble.
- Credit mix (10%) -- Lenders want to know that you can be responsible with different types of credit accounts (mortgage, auto loan, credit cards, etc.), not just one or two. In other words, someone with a track record of paying off a mortgage, student loan, and a couple of credit cards could look like a better credit risk than someone who only had experience with one of those.
The good will likely outweigh the bad
Here’s the first point to notice. The only reason that a personal loan can hurt you is that it’s considered new credit. When you apply, a credit inquiry will appear on your credit report, and the new account will be a negative factor. However, take note that the new credit category makes up only 10% of your FICO® Score, so it’s easily overcome by the positive influence from the other categories.
Specifically, as you make your monthly payments on time, you’ll develop a strong payment history and the outstanding balance of your loan will decrease over time. The categories represented by these two principles make up 65% of your score. Both the inquiry and “new credit” status of the account will disappear after about a year.
Furthermore, if you use your personal loan to pay off credit card debt, you could get a big credit boost. Not only does the FICO formula consider installment debt (like personal loans) generally more favorably, but you’ll be leaving your credit cards with little or no balances. In fact, when I obtained a personal loan to consolidate credit card debt, my FICO® Score increased by over 40 points within two months, even though the total amount of my debt hadn’t changed much.
When a personal loan will hurt your credit
To be clear, the short answer I gave earlier only applies if you exhibit good financial behaviors before and after you obtain your personal loan. There are certainly some ways a personal loan can hurt your credit if you aren’t responsible with it.
For example, late payments on a personal loan can prove to be devastating to your credit. Typically, a payment gets reported when it’s 30 days late or more, but that doesn’t mean you should test this. Paying your loan on time every month is crucial to protecting your credit score -- not to mention avoiding late fees.
In addition, if you apply for a personal loan at the same time as you apply for (or open) a bunch of other credit accounts, it could magnify the “new credit” negative effect. A single new account or credit inquiry is unlikely to drop your FICO® Score by more than a few points, but if you apply for say, a dozen new credit accounts within a few months, the effect could be far larger.
A personal loan will likely be a long-term positive
As I mentioned, there’s no way to know the exact effect a personal loan could have on your credit score. There are simply too many different possible credit and loan scenarios, plus the specific FICO formula is a well-kept secret.
Having said that, you should generally expect your credit score to experience a mild initial drop, but beyond the initial hit, a responsibly managed personal loan should be a strong positive catalyst over time.
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