Loans and how you manage them are the most important factor in your credit. But credit is complicated. Depending on the state of your credit, loans can either help or hurt your credit scores.
New and existing loans can affect your credit in several ways:
- They help you build credit if you successfully make payments.
- They hurt your credit if you pay late or default on loans.
- They reduce your ability to borrow (which might not directly affect your credit scores).
- They cause slight damage to your credit at first, but they can easily recover if you make payments on time.
How Building Credit Works
Your credit is all about your history as a borrower. If you’ve borrowed and repaid loans successfully in the past, lenders assume that you’ll do the same in the future. The more you’ve done this (and the longer you’ve done it), the better.
Taking out a new loan gives you the opportunity to repay successfully and build up your credit. How much debt you have, including the loans you take out, determines 30% of your credit score. How reliable you are at paying off that debt, known as your payment history, makes up 35% of your credit score.
If you have bad credit—or you have never yet established credit—your credit score will improve with each monthly on-time payment.
|How Your Credit Score Is Determined|
|Length of Credit History||15%|
Getting different types of loans also helps your credit. Ten percent of your FICO credit score is based on your “credit mix,” which looks at the variety of accounts on your credit report. You can still have a good score if all of your loans are credit cards, but your mix is better if you also have an auto loan or a home loan.
How Missed Loan Payments Impact Your Credit
Taking out loans can improve your credit mix and expand your borrowing history, both of which can improve your credit. If you pay late or stop making payments, however, your credit will suffer.
Missed payments and outstanding debt both negatively impact your credit score. Once your score drops, you will have a harder time getting new loans.
If you start to have trouble making payments, talk to your lender. You may be able to negotiate your interest rate, refinance your loan, or consolidate multiple loans to lower your monthly payment.
Don’t borrow just for the sake of trying to improve your credit. If you borrow money that you are unable to pay back, you will end up damaging your credit score. Instead, borrow wisely, if and when you need to, and use the right loan for the situation.
How New Loans Impact Your Ability to Borrow
New loans affect more than just your credit score; they also reduce your ability to borrow.
Your credit reports show every loan you’re currently using, as well as the required monthly payments. If you apply for a new loan, lenders will look at your existing monthly obligations and decide whether or not they think you can afford an additional payment.
To do so, they calculate a debt to income ratio, which tells them how much of your monthly income gets eaten up by your monthly payments. A lower ratio means you have more available income and are more likely to be given a loan.
How Cosigned Loans Impact Your Credit
You don't have to be the one borrowing for new loans to impact your ability to borrow. If you cosign a loan, it shows up on your credit report.
Because you’re responsible for repaying the loan if the primary borrower does not repay, lenders generally count that as a monthly expense even if you’re not making any payments. This can hinder your ability to take out new loans or damage your credit score if the borrower defaults on payments.
The Credit Dip From New Loans
New loans generally create a slight dip in your credit scores.
Every time you apply for a new loan, lenders check your credit. When they do so, an “inquiry” is created, showing that somebody pulled your credit.
Inquiries can be a sign that you’re in financial trouble and you need money, so they pull your credit score down slightly. One or two inquiries aren’t a big deal, but numerous inquiries can damage your score.
Shopping among lenders is a smart way to get a good deal. To minimize the impact of the credit dip, do all of your shopping within a relatively short time frame.
- If you’re buying a home and comparing mortgage lenders, complete all of your applications within 45 days or less.
- If you're comparing auto loans, complete your inquiries in two weeks or less.
If you have strong credit, any dip in your credit score will probably be short-lived and insignificant. If you have poor credit (or you’re building credit for the first time), that dip could last a little longer, generally until you start making enough payments to improve your payment history.
To avoid the negative impact of this dip, don't take on new debt before you apply for a major loan like a home loan.