A loan is money that one person (the lender) gives to another person (the borrower) with a promise that a repayment will be made within a certain time period. 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 represents 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. Bad credit, on the other hand, implies that it's not likely you will pay your bills to the creditor on time. 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 continue to do so.
Your payments on a loan (and even undertaking the loan itself) have 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 about 10% of your credit score comes from the number of credit 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 history. 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 for your credit score.
If you’re shopping around for a mortgage loan or auto loan, you have a grace period during which multiple loan inquiries won't each have an effect on your credit score. Even after you’ve finished your 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. 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 score. Timely loan payments will give you a good credit score—and make you a more attractive borrower—while late loan payments will flag you as a high-risk borrower.
Because of penalties and interest, missing a loan payment can quickly snowball into more late payments. This road can ultimately lead to a serious issue such as repossession of your car or foreclosure on your home. These are not only serious difficulties, but also damage your credit even further.
High Loan Balances May Harm Credit
The balance of your installment loan also influences your credit. You’ll gain credit score points as you pay your balance down, because creditors will see this as a sign that you will reliably pay off your debt. 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 payment comprises part of your debt-to-income ratio, which is a measure of the amount of your income that you spend on debt payments. For example, a person making $5,000 per month with loan payments totaling $1,500 per month would have a debt-to-income ratio of $30%.
What's the ideal debt-to-income ratio? It depends on the lender and several other factors, but most lenders look for a total DTI ratio (for installment loans) of less than 43%, sometimes even 36%. Many will also want your mortgage payment to take up no more than 28% of your income.
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 rating system, so their proprietary credit scores 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.