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How Does a Personal Loan Affect Your Credit Score?

Kate Smalley

Dec 07, 2021 7 min read

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How personal loans impact your credit
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    A personal loan can both help and hurt your credit score—it depends how you manage it. In the short-term, taking out a loan may temporarily lower your credit score and make it more difficult to obtain additional credit. In the long term, it might boost your credit score if you make your payments on time. Before taking out a loan, always do your research and compare options to find the best loan for you.

    Is Applying For a Personal Loan a Hard Inquiry?

    Applying for a personal loan results in a hard inquiry on your credit report. A hard credit inquiry happens when a lender checks your credit before approving you for a loan. This lowers your credit score by a few points. A soft credit inquiry happens when you receive a pre-approved offer from a lender, or when you check your own credit score with a service like Borrowell. Soft credit inquiries do not affect your credit score. 

    The dip caused by a hard inquiry on your credit score is temporary and shouldn’t be noticeable in the long run. However, be mindful that many hard inquiries in a short period of time can cause a more significant dip in your score. If you’re applying for a bunch of different loans all at once, it can give lenders the impression that you’re a high risk customer in a vulnerable financial position. When you’re shopping around for a personal loan, always do your research before applying to ensure you have a high likelihood of being approved. With a service like Borrowell, you can see your loan approval chances for different lenders based on your current credit score.

    How Can a Personal Loan Help You Improve Your Credit Score?

    A personal loan can improve your credit score in the long term by contributing to your credit mix, helping you build an on-time payment history, and lowering your credit utilization ratio

    Your credit mix refers to the different types of credit accounts you have—credit cards, loans, mortgages, etc. Lenders like to see that you’ve been able to manage many types of credit responsibly. Similarly, making your payments on time and following the terms of your loan signals to lenders that you’re a responsible borrower. This helps build your credit.

    While a personal loan doesn’t directly factor into your credit utilization ratio because it’s an installment loan, using it to pay off revolving credit (such as a credit card) could lower your credit utilization ratio. This type of loan is often known as a debt consolidation or credit card consolidation loan, and it can help you manage your debt and improve your credit over time. 

    How Can a Personal Loan Harm Your Credit Score?

    In the short term, a personal loan can harm your credit score by causing a hard inquiry on your credit report and getting you into more debt. In the long term, a personal loan will damage your credit if you’re unable to make your payments on time, if you can’t cover fees, or if you default on the loan altogether. Here’s a further breakdown of how a personal loan might hurt your credit score, especially if it’s not managed properly.

    Creating a hard inquiry on your credit report

    Applying for a personal loan creates a hard inquiry on your credit report. This will lower your credit score by a few points. The dip in your score should only last for a few months, however multiple hard inquiries can cause more damage to your score. This is why it’s important to understand your credit score and report before applying, and to minimize the number of applications you make.

    In general, if you already have good credit and a history of managing debt well by making timely payments, the impact of a hard inquiry on your credit score will be lessened. 

    Taking on more debt

    Taking out a personal loan also means taking on more debt. It can make sense to use a personal loan to pay off high interest debt, such as credit card debt, but ensure that you’re changing the habits or situation that resulted in debt in the first place. Having additional sources of credit that you max out or can’t make the payments on will put you in a financially precarious situation and damage your credit score.

    Missed payments and additional fees

    It’s important that you’re able to cover the payments on your loan and any additional fees related to your loan agreement. If you can’t, or if you miss a payment, you might be charged fees and your credit score will suffer. All missed payments are reported to credit bureaus. If you continue to miss payments, you will default on your loan. This causes significant damage to your score and makes it more difficult to get credit in the future.   

    What Is the Credit Score Requirement for a Personal Loan?

    Credit scores range between 300 and 900. In Canada, a credit score between 660 and 712 is considered fair, a score between 713 and 740 is considered good, and a score between 741 and 900 is considered excellent. If you have fair or above credit you’ll have access to loans from most prominent lenders in Canada, such as banks. The higher your credit score, the more options you’ll have with lower interest rates.

    A credit score between 575 and 659 is considered below average and a score between 300 and 574 is considered poor. With below average or poor credit you will have a hard time accessing a personal loan. Some alternative lenders specialize in offering loans to those with below average credit, but be extremely careful of the fees and terms associated with these loans. The interest rates can be up to 30% because you are seen as a riskier customer. 

    If it’s not an emergency, work to improve your credit score before applying for a loan. Keep in mind that some lenders will look at factors other than your score when deciding to approve you for a loan. They may consider your income, bank balance, or employment history. 

    With Borrowell, you can check your credit score for free and see your approval chances for specific loans based on your credit score. This can help you take out the guesswork when shopping around for loans and help you apply with confidence.

    Is a Debt Consolidation Personal Loan Harmful to Your Credit?

    Taking out a personal loan to consolidate your debt is a popular option. When used properly, debt consolidation can improve your credit. A debt consolidation loan can be a good way to pay off your debt sooner by lowering your overall interest rate and reducing your overall payments. It’s also easier to manage one payment on one loan instead of many payments for multiple loans or credit cards.

    In the short term, applying for a personal loan will cause a dip in your score as it’s a hard inquiry on your credit report. Opening a new credit account can also temporarily lower your score because it lowers the average age of your credit. It can also make it harder to access other sources of credit in the near future. If you apply for a car loan or a mortgage shortly after taking out a personal loan, you might be rejected because you already have as much debt as you can manage.

    In the long run, your credit score should recover and even improve by making all your payments on time. 

    In Which Other Circumstances Should a Personal Loan Be Considered?

    A personal loan is a common and effective way to consolidate high interest debt, such as credit card debt. Other situations where a personal loan can be helpful are to finance a major expense such as a home remodel or a wedding, or to resolve a high-cost emergency. 

    As with any kind of debt, be mindful of how much you take on and what it’s for. If you can, save up in advance for large expenses. Work to build up an emergency fund so you don’t have to rely on credit to cover unexpected expenses. And don’t borrow money you don’t need.

    Buy-now-pay-later (BNPL) loans allow you to finance a big purchase over time using a series of installment payments. BNPL loans are becoming more popular in Canada and are available to use with certain retailers. The exact credit score requirements for BNPL loans will vary between retailers.

    The main risks involved with using a BNPL loan include borrowing more than you can pay back, paying a high interest rate, and hurting your credit score if you miss your installment plan payments. If you have a good repayment plan in place, then using a BNPL payment option like Affirm PayBright can be useful in breaking up your purchase into more manageable payments.

    The Bottom Line

    A personal loan can negatively impact your credit score in the short term and help build it in the long term. Before applying for a personal loan, have a thorough understanding of your credit score, work to improve it if needed, and shop around to get the best rate possible. Continue to monitor your score and practice healthy credit management to improve your credit over time.

    Kate Smalley
    Kate Smalley
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    Kate is a Toronto-based writer and marketing communications consultant. Kate is a Qualified Associate Finacial Planner (QAFP) is passionate about having open and honest conversations about money. She's also really into crafting: she has 3 sewing machines.

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