Proceeding with caution is essential before acquiring a personal loan. Before signing any paperwork, thoroughly understand the loan's terms and conditions.

Did you know in the last quarter of 2023, Americans have a total of $241 billion in personal loan debt where the average personal loan debt per borrower is $11,692. Now you might be asking yourself if this is the right move for you, especially if you struggled with a low credit score and just recently improved your credit.

This guide will break down the impact of personal loans on your credit score in a way that's easy to understand, so you can make informed financial decisions.

What Is a Personal Loan?

A personal loan is a type of unsecured loan, meaning it doesn't require you to put up collateral like a car or house to borrow money.

This makes them easier to obtain than secured loans like mortgages, but also typically come with higher interest rates. Personal loans are offered by various lenders, including banks, credit unions, and online institutions.

They function like any other loan: you borrow a specific amount, agree to repay it with interest over a set term and make fixed monthly payments.

So, why do people take out personal loans? There are several reasons: debt consolidation, financing a large purchase (new appliance, dream vacation, etc.), or covering unexpected expenses (medical bills or car repair).

Positive Impact of Personal Loans on Your Credit

Although personal loans might be primarily viewed as tools for debt consolidation or financing specific needs, they offer surprising benefits for your credit score, going beyond simply providing access to funds. Here’s how personal loans can help you improve your credit score.

Building a Positive Payment History

This is the biggest advantage. Making consistent, on-time payments on your personal loan demonstrates your ability to manage debt responsibly, which is the single most significant factor influencing your credit score (accounting for 35%).

Every timely payment contributes positively to your credit history, building a strong track record for future borrowing.

Improving Credit Mix

Your credit mix, which contributes 10% to your score, refers to the variety of credit accounts you hold.

Having only credit cards, for instance, signifies limited credit experience. Taking out a personal loan, which is an installment loan (fixed payments over a set term), adds diversity to your credit mix, potentially improving your score.

Lowering Credit Utilization Ratio

Unlike credit cards, where your outstanding balance affects your score monthly, personal loans are installment loans. This means your credit utilization ratio (amount of credit used divided by total credit limit) isn't directly impacted by the loan itself.

However, using a personal loan to consolidate high-interest credit card debt can significantly reduce your overall credit utilization. Ideally, keeping this ratio below 30% is considered good practice for maintaining a healthy credit score.

Negative Impact of Personal Loans on Your Credit

Personal loans may offer an array of benefits, but it also come with potential drawbacks that can negatively impact your credit score. Here’s how personal loans can hurt your credit.

Hard Inquiries

Every time you apply for a loan, including a personal loan, the lender performs a "hard inquiry" on your credit report. These inquiries can temporarily lower your credit score by a few points, especially if you apply for multiple loans in a short period.

The impact is usually minimal and disappears after a year or two, but it can be detrimental if you're planning to apply for other loans, like a mortgage, in the near future because lenders view it as a sign of potential financial stress.

Increased Debt

Taking out a personal loan simply adds to your overall debt burden. This can raise your credit utilization ratio, which is the percentage of your available credit limit that you're using.

A high utilization ratio (generally above 30%) negatively impacts your credit score, signaling to lenders that you may be overextended financially.

Missed or Late Payments

This is the most significant negative impact. Missing even one payment on your personal loan can cause a significant drop in your credit score and stay on your credit report for up to seven years.

Consistent late payments can further damage your score and make it difficult and expensive to borrow money in the future.

Final Thoughts

So, is a personal loan right for you? It depends on your financial situation and goals.

While personal loans can be helpful tools for consolidating debt, financing large purchases, or covering unexpected costs, they also come with potential risks.

Keep in mind that making on-time payments is important to building a positive credit history, and taking on more debt can negatively impact your score if not managed responsibly.

Before making a decision, carefully consider your options, weigh the pros and cons, and ensure you can comfortably afford the monthly payments. If you're unsure, consulting a financial advisor can help you make an informed decision.