From time to time, it’s necessary to take out a personal loan for debt consolidation, home renovations, or other reasons. But even the best personal loans can affect your credit score. With that in mind, let’s break down how loans impact your credit so you’re fully aware.
Hard Credit Checks
For starters, every personal loan lender, whether it’s a bank, credit union, or any other financial institution, will perform what’s called a “hard credit check” before they determine whether they will give you a loan or not.
A hard credit check knocks down your credit score by a few points because it shows the credit unions that you need money now, rather than having saved up money for whatever purchase you need to make. Hard credit checks are unavoidable, but they don’t knock down your score too much in isolation.
Note that “soft” credit checks don’t decrease your credit score. These are often offered by lenders that provide pre-qualification for their loans.
New Credit Accounts
Similarly, opening up a new credit account or taking out a new personal loan may also decrease your credit score by a few points. This isn’t a guarantee and it often depends on how many credit accounts you have open at the time (i.e. how many loans are in your name or how many credit cards you have). But don’t be surprised if your score goes down by another few points whenever you take out a new personal loan.
If you only have a single loan or credit card in your name, opening a new credit account will probably not decrease your credit score by much, if at all. The odds of a point decrease for taking out a new loan increases as you open more and more credit accounts.
Naturally, if you miss payments or don’t pay off your personal loan, you will dramatically decrease your credit score. This is something you should attempt to avoid at all costs as it has the biggest impact on your credit score.
Paying On-Time or Early
If you pay off your loans on time or even early (which is recommended), you show creditors and lenders that you are very trustworthy with their money. This will increase your credit score and make them more likely to approve you for another loan in the future.
In fact, you should always practice the debt snowball method by paying off any small loans or debts as early as possible. This will eliminate the pressure of their interest rate(s) and allow you to focus on larger debts progressively.
Either way, paying off your loans on time will improve your credit score across the board. Paying off your personal loan early is always the better choice if you can afford it. You will accrue less interest so you’ll pay less over the loan’s term or lifespan.
Can Personal Loans Boost Your Credit Score?
While personal loans have the potential to decrease your credit score significantly, they can also improve your credit score in one major way: boosting your creditworthiness. They do this by increasing your available credit, increasing your number of credit accounts, and proving you pay your debts on time.