A personal loan is one of the simplest ways to borrow money. It’s also a relatively cheap form of credit, and the best personal loan providers allow you to repay early, so it can be flexible too.
But, like any form of credit, it has an impact on your credit score. That doesn’t mean you shouldn’t take one, but it does mean that you should consider the impact and balance the pros and cons before making a decision.
In this article, we’ll explain exactly how a loan affects your credit score and what you can do about it.
But if you just want a quick answer, here it is: your credit score will take a short term hit when you take out a personal loan. As you pay the loan off, your score will recover - and should actually be higher once you’ve paid it off in full.
If you’re looking for a flexible personal loan of £1,500-12,000, you can take a look at our loan calculator or make an application at www.koyoloans.com. Representative APR 27%
By now, you’ve already learned what a personal loan is, and you’re wondering how it affects your credit score. If you want to know what credit score you need for a personal loan, we also covered that.
How does a personal loan affect a credit score?
To start with, we need to remind ourselves what a credit score is: credit agencies like Experian and Equifax gather data on borrowers, and sell that data to lenders. They often simplify this information into a single number - that’s your credit score.
There are dozens of factors that go into your credit score, but here are the main ways that taking out a loan might have an impact:
- When you make a loan application, your lender may carry out a credit check. If that’s what’s known as a “hard inquiry”, it will appear on your credit report - and if you have a very high number of hard inquiries, it could affect your score
- Taking out a loan means taking on more debt. That has a negative effect on your score (1)
- Making your monthly payments over the loan term will boost your credit score, BUT...
- ...if you make a late payment or fail to repay in full, your score will be seriously affected - that’s likely to affect your ability to borrow again in future
How much does a loan affect your credit score?
In truth, the only people who can give you a precise answer here are the three credit bureaus that calculate credit scores: Experian, Equifax and TransUnion.
Sadly, they don’t make their calculations public, so all we can do is speculate based on what they do publish. For example, they do generally make it clear that the most important factor in a credit score is managing money responsibly - that doesn’t mean that you shouldn’t borrow. For example, here’s what Experian say:
“A good credit score generally comes from a history of managing money responsibly. This doesn’t mean you shouldn’t borrow money though – in fact, companies often like to see a track record of timely payments and sensible borrowing.” (2)So while taking out any type of loan does affect your credit score, it’s just one of a number of factors. The most important thing to remember is only to borrow what you can afford to pay back.
Does a personal loan show up on a credit report?
Absolutely. Your credit report shows not just loans which are currently outstanding, but also loans which you’ve paid off recently (these count favourably) and missed personal loan payments (these count negatively).
It will count all formal types of borrowing, including bank account overdrafts, credit cards, student loans and debt consolidation loans.
The good news is that most negative marks on your credit history will disappear after six years (3), giving you a clean slate.
Irrespective of your credit score, if you already have a significant personal loan outstanding, a lender might have concerns about lending more to you - that’s because responsible lenders take affordability very seriously, and look at the total amount outstanding across all loan types of credit (including your credit card balances) to avoid lending you more than you can afford to repay.
Similarly, if you are using all your available credit (e.g. you’ve maxed out all your cards), a borrower might think twice about offering you a car loan, irrespective of your rating.
Related post: We explain how to get a car with a bad credit score in our guide full of insider tips, covering car loans, HP, PCP and lesser-known alternatives.
Is it better to have a personal loan or credit card debt?
Again, this is something that only the credit bureaus know for sure, and the answer is likely to depend on your circumstances, but a few things to consider if you’re looking at personal loans vs credit cards:
- Cost - which form of credit is cheaper for you? This will be determined by the interest rate and how quickly you are able to pay off the loan, but a personal loan is often cheaper over the long term
- Flexibility - do you want to be able to dip in and out? If so, a credit card is a good option
- Loan amount - depending on your circumstances, there’s a good chance you can borrow more through a personal loan than via a credit card.
Will my credit score increase if I pay off a personal loan?
Yes - paying off a personal loan in full is one of the best things you can do to boost your credit score. The whole reason lenders perform credit checks is to find out whether you’re a borrower who can be relied upon to pay the money back. So, from the lender’s point of view, if you’re the sort of person who has paid off money in full before then you’re an attractive potential borrower.
In fact, if we dig into the Experian statement a little more, we have the line:
Companies [lenders] often like to see a track record of timely payments and sensible borrowing (4)
What this means is that some lenders would prefer to lend to a borrower who has taken out new credit in the past and repaid it, rather than someone who has never taken out a loan and therefore has no track record.
Of course, a borrower who has never taken out a loan has never missed a payment, but that’s only true in the same way that the Queen has never lost a fight to Mike Tyson - there’s no track record to base a decision on.
That’s not to say that you should take out a personal loan just to boost your credit score - you’d be paying fees and interest - but it does explain why some borrowers who have never missed a payment might want to consider a lender like Koyo, which relies on Open Banking data rather than a credit score.
Should I apply for a personal loan if I’m worried about my credit score?
A good credit score isn’t an end in itself - it’s just a reflection of things like your payment history, and your credit mix which lenders use to make decisions.
The only useful thing about a good credit rating is that it will help you to borrow - now or in the future. A good credit score will generally give you more choice, a higher credit limit and lower interest rates.
So deciding not to borrow with the sole aim of protecting your credit score doesn’t really make sense. And don’t forget that a good credit score will generally get you a better deal on a loan, but it’s not a prerequisite - we’ve put together a separate guide to the best loans for borrowers with a “fair” credit score.
However, if you’re worried about your credit score because you think you might not be able to make repayments on a loan then you should absolutely reconsider. Taking out a loan you can’t repay can lead you into serious financial difficultiesCredit scores can be complicated to understand, but hopefully the article above has helped to make things simpler. And if you want to know more, you can take a look at our guide to personal loans or ask us a question below.
Now that you’ve read our article on personal loans and credit score, you might want to take a look at some of the options available to you. Our loan calculator is a great place to start.