by Matt Frankel, CFP | Updated July 21, 2021 - First published on July 20, 2019
Many or all of the products here are from our partners that pay us a commission. It’s how we make money. But our editorial integrity ensures our experts’ opinions aren’t influenced by compensation. Terms may apply to offers listed on this page.
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.
Tips and tricks from the experts delivered straight to your inbox that could help you save thousands of dollars. Sign up now for free access to our Personal Finance Boot Camp.
By submitting your email address, you consent to us sending you money tips along with products and services that we think might interest you. You can unsubscribe at any time. Please read our Privacy Statement and Terms & Conditions.
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.
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.
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.
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.
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.
The Ascent team vetted the market to bring you a shortlist of the best personal loan providers. Whether you're looking to pay off debt faster by slashing your interest rate or needing some extra money to tackle a big purchase, these best-in-class picks can help you reach your financial goals. Click here to get the full rundown on The Ascent's top picks.
We're firm believers in the Golden Rule, which is why editorial opinions are ours alone and have not been previously reviewed, approved, or endorsed by included advertisers. The Ascent does not cover all offers on the market. Editorial content from The Ascent is separate from The Motley Fool editorial content and is created by a different analyst team.
The Ascent is a Motley Fool service that rates and reviews essential products for your everyday money matters.
Copyright © 2018 - 2021 The Ascent. All rights reserved.