How Borrowing a Loan Impacts Your Credit Score
How a Loan Affects Your Credit
A loan is money that’s been given from one person (the lender) to another (the borrower) with a promise to repay. When you borrow a loan, you typically sign a contract agreeing to make a certain number of payments for a certain amount by a particular 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 indicates you’re not likely to pay your bills on time.
Your payments on a loan and even borrowing the loan itself has an impact on your credit, more specifically, your credit score which is the numeric snapshot of your credit history at a given point in time.
Loan Applications Impact Your Credit
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’re desperate for a loan or that you’re taking on more loan debt than you can handle.
If you’re shopping 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’re done rate shopping, the loan inquiries are treated as a single application rather than several. That window of time is between 14 and 45 days depending on which credit score the lender checking your score is using. Aim to keep your loan shopping within a small frame of time to lessen the impact to 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. Since payment history is 35% of your credit score, making on-time payments is essential to building a good credit score. Even a single missed payment can hurt your credit score.
Timely loan payments will help improve your credit score, making you a more attractive borrower. However, 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 and foreclosure.
High Loan Balances May Harm Credit
The balance of your loan 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 as it compares to your income isn’t included in the credit score that’s sold by FICO and the credit bureaus. But, many lenders consider income a factor in your ability to repay a loan, so their proprietary credit scores may use your debt-to-income ratio as a credit consideration.
Your debt-to-income ratio compares all your loans and credit cards to your total income. A high debt-to-income ratio could raise your risk score with the lender and get you denied for loans.