Personal Loans May Increase Credit Scores of Most Borrowers
Americans are increasingly turning to personal loans as another option for their ongoing debt and credit needs. There are many uses for personal loans, and the most prominent are to consolidate existing debt and pay down credit cards, which often carry higher interest rates.
Paying off credits cards generally has a positive impact on credit scores because credit score models take into account how much of a person’s available credit is used up. Generally speaking, the more of your available credit you use, the lower your score will be. Credit score models also look favorably on a mix of loan types (if they’re in good standing), so your score could inch up if you add a new loan type to your credit history.
For these reasons, some people expect their credit scores to rise after opening a personal loan, even though the hard credit check a lender runs before finalizing the loan may temporarily lower a person’s score.
But do people see their credit scores rise after taking out a personal loan? LendingTree analysts looked at the scores of people who took out personal loans to see how their credit scores changed after one month, three months, six months and 12 months. We broke the analysis down by credit score band in order to look at people with at least somewhat similar credit profiles.
The short answer: Most people see a small bump in their scores immediately, but scores tend to decrease and are often a few points lower after one year.
- About 62% of borrowers see their credit scores go up the month after they take out a personal loan.
- After 12 months, around 45% of borrowers still have higher scores than they did in the month of loan origination.
- People with lower scores are more likely to see a credit score bump: 68% of those who started with scores under 620 saw their scores increase in one month, 71% had higher scores after three and six months, and 58% had higher scores after a year.
- People with scores under 620 saw a 20 point, or 3.4%, boost after one month. They also saw a 10 point, or 1.8%, boost after 12 months, on average.
- On the other end of the spectrum, borrowers who started with higher scores are less likely to see a credit score bump. 57% of people with scores of 750 or higher see their scores increase after a month, and about 39% have higher scores after a year.
Credit score bumps aren’t long lasting
62% of borrowers see their scores go up a month after taking out a personal loan, but the number of borrowers who maintain that increase goes down over time. After 12 months, 45% have scored higher than when they originated the loan.
In fact, after one month, borrowers see their scores rise by 11 points, on average, but after six months scores are back down to where they started. Worse yet, after 12 months borrowers see scores that are an average of 10 points lower than they were during the month that their loans originated.
The reason for the dropping scores may be related to the reason the loan was taken out in the first place. For example, if someone took out a personal loan to manage their credit card debt, it’s possible that the conditions that caused the original run up on cards — whether because of financial missteps or a financial crisis — will reassert itself after the loan is taken out. That borrower may start charging their cards again, even though they’re making monthly payments on the personal loans, potentially leaving them in a worse spot than where they started. That can lead to missed payments, which means lower scores.
But it’s important to realize that different borrowers see different effects on their scores following a personal loan.
Lower starting credit scores see higher jumps after loan origination
The lower someone’s starting score, the more likely they are to see a credit score increase, the bigger the increase will be, and the more likely they are to maintain it for a year. This is encouraging and dispels the notion that those with poorer credit scores are more irresponsible with their personal loans.
Across the credit bands we reviewed, the lower the starting score band, the higher the percentage of borrowers who saw their scores increase. This holds for all of the time periods we reviewed, except for the first and last months, where people with scores of 750 or higher were more likely to have a higher score than the credit band directly below them (700-749).
Seventy-one percent of borrowers with scores below 620 have higher scores three and six months following their loan, which drops down to 58% after 12 months — still a clear majority. That translates to an average 20 point increase at one month, before dropping to an average of 10 points after 12 months. Interestingly, this is the only group that maintains their credit score boost for six months.
Meanwhile, 38% of borrowers who started with scores between 700 and 749 and 39% of those with a starting score of over 750 had a higher score one year after taking out a personal loan.
Why isn’t everyone seeing a credit score increase?
Credit score models take a lot of factors into account, and borrowers who take on personal loans do so for different reasons and under different conditions. In other words, we shouldn’t expect uniform outcomes, nor can we make overarching generalizations. Combinations of what follows may apply to some people, but not to all.
Not everyone is using their personal loans to pay down credit cards. At the end of the day, additional debt is additional debt and can have a deleterious effect on credit scores.
People may take on personal loans to pay for a large event, like a wedding or vacation. Personal loans may not cover every ongoing expense and borrowers may run up additional costs on their credit cards.
“Hard credit pulls” ding credit scores. Before closing a loan, or sometimes when assessing a potential borrower, lenders will pull a borrower’s credit report to confirm their eligibility for loan terms, and that tells the credit bureaus that the potential borrower is looking for money. The credit score models will lower a person’s score a bit because someone looking for more credit could be in financial crisis.
Closing credit cards after paying them off can lower scores. It’s kind of ironic that people who close their cards in an effort to take control of their credit and debt issues are likely to see their credit scores drop in response. This is because credit score models look at the age or “seasoning” of a person’s account and give higher scores to people with older accounts, so closing an older credit card removes the demonstration that a borrower has responsibly managed that account over a long period of time. Additionally, fewer credit cards mean a lower credit limit, which means balances take up a larger percentage of available credit, which can mean lower scores.
Credit scores may already be at their ceilings, based on the borrower’s payment history and account seasoning. If something like high credit card utilization isn’t dragging a person’s score down, the ding they get from a hard credit card pull may be the only change they see.
Borrowers could be in financial distress when they take out the loan, and that situation may get worse over the course of a year. For example, if someone who loses her job takes out a personal loan while her credit profile is still good, she may have trouble paying her bills or continue to run up cards as months go by without a new job.
Bad habits die hard. Unfortunately, the spending habits or financial conditions that caused someone to overuse their credit cards or pay bills late can reassert themselves after a person has taken on a personal loan. Some people see credit cards without balances and feel compelled to charge them up, even though they have a monthly personal loan bill. Others find that they simply can’t afford the basics or their lifestyle costs with their current incomes.
Using personal loans responsibly
Personal loans can be an incredibly useful financial tool, but as with any debt product, it can also be the wrong financial choice. They are not designed to be credit recovery tools, although some people do recommend using them that way, depending on circumstances.
Paying down credit cards or consolidating other debt to make monthly payments more manageable are the most common reasons for taking out a personal loan. This can be a great option for people, as long as borrowers are absolutely sure that they won’t fall short on all of their monthly bills and expenses going forward, thus running up debt again. People who would still be scraping the limits of their incomes to meet expenses need bigger changes than a personal loan can provide, such as cutting back on their lifestyles or increasing their incomes to reach financial stability.
Borrowers need to know themselves: Are they easily tempted when they see their available credit limits go up? Are they prone to completely ignore their finances for weeks at a time? If so, additional steps are necessary to curb impulse spending, such as locking credit cards away, using personal finance and budgeting apps, and seeking professional guidance to reorient their attitudes toward spending.
It’s also inappropriate to think of personal loans as freeing up money for other, non-essential expenses, like an upgraded car, new furnishings or little luxuries. Debt — especially unsecured debt — is expensive and it’s almost always cheaper to save up and buy something outright.
There may be better options than personal loans. Someone who seeks a personal loan to cover medical expenses, for example, might have better luck negotiating monthly payments directly with the provider. People with high interest credit card balances may be eligible for a no-interest balance transfer card that covers the amount and length of time required to pay off the balance.
Those seeking to improve their credit scores probably shouldn’t take on debt to do so. There are other options and tools, and borrowers should stick to reputable companies and free services, except in extreme cases like recovering from extensive identity theft.
Analysts tracked the credit scores of over 1,800 anonymized My LendingTree at five moments in their credit histories: the month in which they opened a personal loan (“month 0”), one month after they opened that personal loan, three months later, six months later, and 12 months later. Credit scores at month 1, month 3, month 6 and month 12 were then compared to their scores at month 0. We then calculated the percentage of people who saw their scores rise and the average credit score changes within credit score bands. The credit score bands are: below 620, 620-659, 660-699, 700-749, 750 and higher.
My LendingTree is a free credit monitoring service available to the general public, regardless of their debt and credit histories, or whether they’ve pursued loans on a LendingTree platform. My LendingTree has over nine million users.