Will a personal loan help or hurt my credit score?

Personal loans are very versatile. You can use them for almost anything, including emergency expenses, home improvements, and more. They're also effective for consolidating multiple loans or credit card debts into a single monthly payment. Instead of worrying about paying different bills at different times and rates, consolidating your payments could help simplify your finances.

However, a personal loan could help or hurt your credit score, depending on your actions. When you strategically use a personal loan, it can help your credit score. But in some circumstances, a personal loan could hurt your credit score. Before applying for a personal loan, it's a good idea to understand your credit score and how a personal loan could affect it.

What you'll learn:

• Understanding your credit score
• When does a personal loan hurt your credit score?
• When does a personal loan help your credit score?

Understanding your credit score

Most lenders consider your credit score and credit history before determining the rates and terms for a personal loan or other type of loan. There are three major credit bureaus in the United States: Experian, Equifax and TransUnion, which record credit scores and credit reports about potential borrowers. Lenders usually divide credit scores into these categories:

• 300 to 629 - poor
• 630 to 689 – average or fair
• 690 to 719 – good
• 720 to 850 – excellent 

Your credit score is calculated from your credit history, and you can get detailed copies of your credit reports from the credit bureaus. The credit bureaus use slightly different methods to calculate credit scores, but they all base about the same percentages of their scores on these criteria:

• 35% payment history
• 30% total amount of outstanding debt or debt-to-income ratio
• 15% length of credit history
• 10% new debt or lines of credit
• 10% credit mix, or the number of loans and lines of credit that someone has 

Understanding your credit score enables you to predict the interest rate you'll receive for a personal loan and compare offers from different companies. For more detailed information, you can check your credit reports (you can get free detailed copies of your credit reports every 12 months from any of the credit bureaus). You can request a copy from AnnualCreditReport.com. If you notice any errors or inaccurate information, you can raise your credit score by disputing it. Learning more about your credit history also makes it easier to improve your credit score.

When does a personal loan hurt your credit score?

Negative payment history. At 35 percent, payment history is one of the most important factors in your credit score. If you don't make your personal loan payments on time and in full each month, your credit score could take a dip. It's essential to evaluate the monthly payment before applying for a personal loan.

Another credit inquiry. When you apply for a personal loan, the lender usually performs a hard inquiry on your credit report. A hard inquiry could temporarily reduce your credit score by a few points. When applying for any loan, it's good practice to ask upfront if the credit check is a hard or soft inquiry.

Increasing your debt-to-income ratio (DTI). Your DTI matters for two reasons. If it's too high, it can prevent you from opening a new loan, such as a mortgage, or put you in a stressful financial situation. Although DTI is not a factor in your credit score, it is still important to calculate your DTI before opening a new loan. A healthy DTI is below 40 percent.

When does a personal loan help your credit score?

Positive payment history. Even when you get a personal loan for home improvements, a fun vacation or another expense, you can use that loan to improve your credit score by making your payments on time. Paying on time helps build your payment history, which is 35 percent of your credit score. It demonstrates to lenders that you can fulfill your responsibilities and repay your debts. This is especially true if you have never had a loan before.

However, if you have a low credit score or a short credit history when you apply for a personal loan, you may need to pay a higher interest rate. While your credit score may drop slightly right after you apply for a personal loan, it could rise as you make your payments on time.

A lower credit utilization ratio. If you use a personal loan to consolidate credit card debt, you could lower your credit utilization score. Credit utilization makes up 30 percent of your score. Credit utilization comes from your revolving lines of credit (i.e., home equity lines of credit and credit cards). It is the ratio of how much you owe compared to your total credit limit amount. For example, if you have two credit cards with a total credit limit of $5,000 and you owe $4,000 at the end of the month, your credit utilization is 80 percent.

When you consolidate credit card debt with a personal loan, you move the debt from the revolving line of credit (the credit card) to the personal loan. In the same example, if you move all $4,000 to a personal loan, your credit utilization would become 0 percent. It's best practice to keep it under 30 percent, so moving debt from a credit card could give your score a big boost.

Another type of credit. Getting a personal loan can also raise your credit score by improving your credit mix, or the variety of credit accounts you have. These accounts can include mortgages, credit cards, lines of credit, vehicle loans, home equity loans and other forms of credit. Having a good credit mix and a strong payment history demonstrates to lenders that you can manage various types of debt effectively. Your credit mix accounts for approximately 10 percent of your credit score.

Slowly lowering your debt-to-income ratio. Debt-to-income is not part of your credit score, but lenders typically look at it when you apply for a loan or credit card. To calculate your DTI, divide your total monthly debt payments by your monthly income. You may be wondering how taking on a new loan can help your DTI ratio. In the long run, if you are using a personal loan to consolidate high-interest debt into a lower-interest loan, you may be able to pay off your debt quicker. As you pay off your debt, your debt-to-income ratio may decrease (as long as you're not taking on new debt).

Note: Even though you may see credit score improvements in the examples above, you should never take out a loan for the sole purpose of raising your credit score.