How do personal loans impact your credit score?
Loans can come in handy when you need cash for large or unexpected expenses. But how does taking out a personal loan affect your credit score? Do personal loans help or harm your credit score? And is it worth using them to build your credit?
This guide will help you understand personal loans and their impact on your credit score, so you can choose what’s best for you.
What’s a loan?
A loan is when you borrow money and pay it back later, usually with some extra money called interest. There are two main types: secured and unsecured.
- A secured loan, also known as a homeowner loan, is backed by something valuable you own, usually your house. If you don’t pay back the money, the lender could take that asset
- Unsecured loans aren’t backed by something you own. For these, things like your salary and credit score can be important for getting approved
Generally speaking, most personal loans are unsecured loans.
What’s a credit score?
A credit score is a rating that shows how good you appear to be at paying back borrowed money. This is known as your ‘creditworthiness’. A higher score could give you access to more borrowing options, higher amounts and better rates. A lower score could mean fewer borrowing options, at worse rates.
What factors influence your credit score?
Companies called credit reference agencies generate credit scores. The main agencies in the UK are Experian, Equifax and TransUnion. Lots of factors influence your credit score.
Here are some examples:
- Your borrowing history and payment performance on current and past debts
- How long you’ve been living at your address and if you’re on the electoral roll
- How much debt you’re in and how long your credit accounts have been open
- How close you are to your credit card limits
- Court records like County Court Judgements or bankruptcy
For more information about credit scores see our guide - why your credit score dropped.
How could a personal loan harm my credit score?
1. Hard search
When you find a loan offer you like and apply, at some stage the lender will do a ‘hard search’ on your credit file. When this happens depends on the lender, but it should be clearly marked. This happens for any new credit, whether it’s for a personal loan, credit card or mortgage.
A hard search will leave a temporary dent on your score. But manage your loan well and make payments on time each month, and you should see your score recover.
⚠️Warning: Avoid too many applications at once
Lots of hard searches over a short period can have a bigger negative impact. That’s because it can look like you’re becoming dependent on borrowing to get by.
Instead, use price comparison websites to help you find offers you’re likely to be accepted for before applying. And remember to space out your applications. If you can, try not to make more than one application in every six months.
2. Late and missed payments
What happens if you miss a payment on your personal loan?
Falling behind on your payments or missing one altogether can really hurt your credit score. Late and missed payments stay on your credit file for a long time - usually 6 years at least.
Other lenders can see these marks on your credit file. And it could mean they’re less likely to lend you money. They might offer you less, or they might charge you higher interest rates.
3. Credit age
Your ‘credit age’ is the average age of all your credit accounts, (how long they’ve been open) and it can have an impact on your credit score.
Provided your accounts have a good payment history, lenders typically see an older credit age positively. Getting a new personal loan could make your credit age younger. And this might lead to a dip in your credit score.
How could a personal loan help my credit score?
1. Add to mix of credit
Having a mix of credit means having different types of credit accounts, like loans, credit cards, overdrafts, and mortgages. If you’re making all your repayments on time, having a variety shows lenders that you can manage different types of credit accounts well.
A personal loan could add to your mix of credit accounts and potentially boost your score, if you always make your payments on time.
2. Show responsible payment history
If you always make your payments on time, you’ll build up a good payment history. Setting up a Direct Debit can help you make sure that you don’t forget any payments.
If you consistently make your payments on time each month, this shows lenders that you can manage credit responsibly. And this can lift your score.
3. Credit utilisation
When you use a personal loan to pay off credit card debt, it changes your ‘credit utilisation ratio’. Mostly, this measures how close you are to your credit limits on your credit cards (the amount of credit you’re using compared to the total amount available to you).
This ratio impacts your credit score. If it’s very high, your credit score might drop, because it can look like you’re relying on credit. Keeping this ratio below 30% is generally considered a smart strategy.
Using a new personal loan to clear your credit card debt typically lowers your ratio, potentially boosting your credit score. Find more information in our guide – is debt consolidation a good idea for me?
Can I apply for a personal loan without impacting my credit score?
Will shopping around for a personal loan impact your credit score?
Just shopping around for a loan on a price comparison website won’t impact your score. Actually, it’s a useful way to see what offers you’re eligible for and compare them. These sites do a ‘soft search’ on your credit file, which won’t have any impact on your score.
If you go on to apply for a loan, it will impact your score. That’s because the lender does a ‘hard search’ on your credit file to get a detailed view of your financial situation and borrowing history. Hard searches leave a mark on your credit file and cause a temporary dip in your score.
Key takeaways
Applying for a personal loan will cause a temporary dent in your score. But go on to manage your loan well and it’ll likely recover and could even go on to improve.
Managing your finances and debts well is an important step to building a healthy credit score and reaching your financial goals.
