How Borrowing a Loan Impacts Your Credit Score
How a Loan Affects Your Credit
A loan is money that one person (the lender) gives to another person (the borrower) with a promise that a repayment will be made. When you take out a loan, you typically sign a contract agreeing to make a certain number of payments for a certain amount of money to be paid by a specific date each month.
In a broad sense, credit is the trust or belief that you’ll repay the money you borrow. You’re said to have good credit when lenders believe you’ll repay your debts (and other financial obligations) on time. However, bad credit implies that it's not likely you will pay your bills on time to the creditor. Your credit is based on how you've handled your previous debt obligations. If you've historically paid on time, lenders have more trust that you'll pay any new debts on time.
Your payments on a loan (and even undertaking the loan itself) has an impact on your credit—more specifically, your credit score which is a numeric snapshot of your credit history at a given point in time.
Loan Applications Impact Your Credit
Did you know that just applying for a loan can lower your credit score, even if it's only by a few points? That’s because 10% of your credit score comes from the number of credit-based applications you make.
Each time you apply for credit, an inquiry is placed on your credit report showing that a business has reviewed your credit report. Several inquiries, especially in a short period of time, may indicate that you are in desperate need of a loan or that you’re taking on more loan debt than you can handle—neither of which is good.
If you’re shopping around for a mortgage loan or auto loan, you have a grace period during which multiple loan inquiries don’t affect your credit score. Even after you’ve finished your rate shopping, the loan inquiries are treated as a single application rather than several applications. That window of time is between 14 and 45 days depending on which credit score the lender checking your score is using. Therefore, you should aim to keep your loan shopping within a small frame of time to lessen the impact on your credit score.
Timely Loan Payments Raise Credit Scores
Once you're approved for a loan, it's important that you make your monthly payments on time. Your loan payments will have a significant impact on your credit. Because payment history is 35% of your credit score, making payments on time is essential to building a good credit score. Even a single missed payment can hurt your credit score. Timely loan payments will give you a good credit score—and make you a more attractive borrower—while late loan payments will damage your credit score. Missing a loan payment can result in a series of late payments followed by a more serious blemish like repossession of your car and foreclosure on your home.
High Loan Balances May Harm Credit
The balance of your loan also influences your credit. You’ll gain credit score points as you pay your balance down. The larger the gap between your original loan amount and your current loan balance, the better your credit score will be.
Your Loan and Your Debt-to-Income Ratio
Your loan amount makes up your debt-to-income ratio, which is a measure of the amount of your income that's spend on debt payments. While your debt-to-income ratio isn't included in your credit score, many lenders consider income a factor in your ability to repay a loan. Some lenders have developed their own so their proprietary credit scores that may use your debt-to-income ratio as a credit consideration. Having a high loan amount may not hurt your credit, but it could raise your debt-to-income ratio and lead to denied loan applications.