If you're looking to consolidate credit card balances or pay off some personal debt, a personal loan can be a viable solution. Although the initial loan application and eventual closing of the account may hurt your credit score slightly, making regular, on-time payments on your personal loan can give your credit score a major boost.
Applying for the Loan
In order to evaluate and approve your loan application, your lender will need to make a hard credit inquiry. Hard inquiries do affect your credit score and may remain on your credit report for up to two years. The amount of hard inquiries you have is a component in the "new credit" section of your FICO score, which accounts for approximately 10 percent of your score weight.
An occasional hard inquiry may not affect your credit score at all. However, if you have multiple hard inquiries over a short period of time, lenders may be concerned that you may be dependent on credit lines and not able to pay back amounts owed.
Once your loan is approved, your credit score reflects a new debt in the amount of the loan balance. Normally, increasing your debt doesn't help your score. However, your credit score can improve if you use your personal loan proceeds to pay down existing credit card debt. This ensures that your credit utilization score -- the ratio of used credit to available credit -- won't go up. Personal loans are considered to be installment loans rather than credit cards, so taking one on can improve your credit mix, which in turn can improve your score.
Making large, consistent payments may be the most significant way your personal loan can improve your credit score. Consistent payments can improve your payment history, which accounts for around 35 percent of your credit score. On-time, complete payments can make an especially big impact if you've had bankruptcies or delinquent accounts in the past, because it shows lenders that you're now able to handle a regular payment schedule.
Paying Off the Loan
Ironically enough, making the final payment on your loan may not provide a credit score boost. Equifax explains that closing an account in good standing doesn't necessarily increase your score. However, that doesn't mean that it makes financial sense to draw out the life of your loan. Especially if you have a high interest rate, a longer-term personal loan means you'll pay more interest over the life of the loan. If you've been making regular payments and using your credit responsibly, closing the loan shouldn't significantly affect your score.