Does applying for a loan hurt your credit score?

When you apply for any type of credit, lenders must perform a hard credit check to view your credit file. This check causes a temporary drop in your credit score. A personal loan also follows this rule — applying for one will knock your score by a few points.

Although the initial application may affect your credit negatively, making timely monthly payments can improve your payment history and credit score over time. Overall, loans can both harm and build your credit depending on how you use them, so it may be helpful to make managing a personal loan a top priority for your budget.

How loan applications impact your credit

Before approving you for a loan, lenders must first check your creditworthiness and financial health. They do this through a credit inquiry or credit check. These checks can be “soft” or “hard,” depending on the purpose of the check.

Soft credit check

A soft credit inquiry or check is more of a general background check than anything else, so it doesn’t impact your credit. Because of this, it can be done with or without your consent, although most lenders will only perform a soft credit check during the preapproval process.

Some lenders offer soft credit checks to see what you may qualify for. This allows borrowers to view realistic offers without having to fill out a formal application and go through a hard credit check.

Hard credit check

When you apply for a personal loan, lenders will run a hard credit check to access your credit report and history. Hard credit checks temporarily lower your credit score by as much as 10 points, but if you have excellent credit, applying for a loan may only cause your score to drop by five points or fewer.

Though your credit score will typically recover within a few months, the hard credit check will stay on your credit report for up to two years. Because of this, lenders must ask for your consent before doing this type of inquiry.

You are required to submit additional documents when you apply for a personal loan, including proof of identity, employer and income verification and proof of address. Have these ready when you apply.

How personal loans could help your credit

When used responsibly, a personal loan can positively impact your credit score in a few ways, like improving your credit mix and boosting your payment history.

• Provides a better credit mix: Adding various types of lending products to your portfolio helps keep your credit score high as long as you stay on top of payments. It is generally a good idea to have a mix of installment loans and revolving credit, as credit mix accounts for 10 percent of your FICO score.
• Makes debt more manageable: If you use a personal loan to consolidate debt, you can generally take advantage of lower interest rates than you’d get with credit cards. With a lower interest rate, you may be able to pay down outstanding debt faster, which will improve your credit score.
• Boosts your payment history: A personal loan can help establish a positive payment history when made in full and on time. Positive payment history makes up 35 percent of your FICO score, the largest category in determining your score.
• Reduces your credit utilization ratio: A personal loan does not affect your credit utilization ratio. However, using one to pay off revolving credit card debt could lower this measure, resulting in a higher score.

How personal loans could hurt your credit

Just like any other credit products, personal loans could potentially lower your credit score in several ways. Making regular, on-time payments will help you avoid some of the damage.

• Hard inquiry on your credit: Due to the hard credit check, you will likely see a short-term drop in your credit score when you formally apply for the loan.
• Late or missed payments: If your payment is late by 30 days or more, the lender will likely report it to one or more credit bureaus. This negative mark can take approximately seven years to fall off your credit report and will ding your score. If enough time has passed and the account goes to collections, your credit score could drop between 90 and 110 points.
• Increase your debt load: When you take out a loan, it increases the amount of debt you have. If you already have too much debt, taking on a loan can limit your future access to credit, as lenders will see you as a greater risk.
• Shorten your credit history: Opening a new loan account can lower the average age of your credit. This could result in a small dip in your score, as length of credit history accounts for 15 percent of your FICO score.

What to consider before taking out a personal loan

Before taking out a loan, consider the benefits and drawbacks of adding another monthly bill to your budget.

• Reason for the loan: Personal loan lenders tend to offer different interest rates depending on the purpose of your loan. For instance, personal loans to consolidate debt may have a lower interest rate compared to one used to finance a vacation.
• How much it will add to your monthly costs: Use a personal loan calculator to determine how much payments will take out of your monthly budget. If you can’t comfortably afford it, you may want to hold off on taking one out.
• Your credit score and history: Do you have a good credit score and healthy habits with your credit? If not, you can take steps to improve your credit score before applying.
• Your debt-to-income ratio: Your debt-to-income ratio (DTI) measures your monthly debt relative to your monthly income. Generally, the higher the DTI ratio, the less likely you will qualify for a loan.

Shopping around for the best personal loan for you is one of the most important steps to take because each lender offers different rates, fees and conditions. It’s especially important to prequalify if you have less-than-perfect credit — getting the best bad credit loan can save you hundreds of dollars in interest.

Bottom line

Personal loans can be a great tool that can help you improve your credit score, consolidate debt or pay off major expenses. However, knowing how applying for a loan can affect your credit score is important. At the end of the day, taking out a personal loan does affect your credit, but there are steps you can take to counteract this decline.

While you may experience a short-term dip when you submit your application, you could improve your credit score over the long run by making timely payments and using your loan funds to pay down existing debt. Finally, before you apply, shop around for the best personal loan rates to get the financing that fits your situation.