How Much Does A Loan Affect Your Credit Score: A Simple Guide
Do Loans Affect Your Credit Score?
Loans are available to help you buy your dream house, drive your dream car, attend the school of your dreams and a myriad of other things you may not be able to afford on your own. How you manage your loans is critical to your financial health. How much does a loan affect your credit score? Let’s find out:
How Loans Can Negatively Affect Credit:
According to TheBalance.com, “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.”
Hard Inquiry:
When you’re seeking a loan for a car or home and a lender requests to view your credit report from the three main bureaus, that’s considered a hard inquiry or hard pull. The reason they’re inquiring is to ensure you have a history of paying back loans and paying your credit card bills on time.
According to FICO, a hard inquiry from a lender will decrease your credit score an average of 5-10 points. Depending on the type of loans you need, it could mean too many hard inquiries.
Loan Applications & Pre-Qualifying:
The first step of any home or car buying loan process is filling out an application and getting prequalified. While this is viewed as a soft pull and will not affect your credit score, the next step will.
Prequalification comes after pre-approval, which does result in a hard inquiry, therefore impacts your credit score. Since people usually look at multiple lenders, it’s not odd to have multiple pulls in a short period of time. At the pre-approval stage, it’s important to complete all your applications within a short period of time, 14 days, as each inquiry will only be looked at as one.
Debt-to-Income Ratio:
In addition to your credit score, your debt-to-income (DTI) ratio is an important part of your overall financial health. Your DTI compares the total amount you owe every month to the total amount you earn. While it doesn’t directly affect your credit score, it’s a piece of the financial puzzle. If you’re not paying off your loans, not only will your credit score suffer, but that balance will catch up with you. Most lenders will look at your DTI, along with your credit score and credit report when they’re deciding whether or not to offer you a loan.
How Loans Can Positively Affect Credit:
Owing money isn’t always a bad thing and if managed properly, it can actually help your credit score.
Payments Made on Time:
When you make loan payments on time, it’s a simple and great way to build your credit. In fact, according to FICO, “payment history makes up 35% of your score and is a major factor in its calculation.”
When a lender sees you’re financially responsible and have paid back what you have owed on time, it gives them peace of mind that you will pay back their loan on time.
Credit Mix:
All of the accounts that make up your credit report is called your credit mix, which determines 10% of your FICO score. While a healthy credit mix can slightly help your credit score, you shouldn’t sign up for various credit cards and loans just to increase it. Concentrate on paying the loans and credit cards that currently make up your credit mix to increase your credit score.
Credit History:
Building credit takes time but can be simple, if you stick to a plan. Any time you borrow money, pay it back on time. There are several ways to utilize your loan to build a healthier credit history.
- Becoming an authorized user on someone else’s account can help you build credit, even if you don’t spend a penny. If you trust someone, like a spouse, family member or friend that is responsible with payments, you can take advantage of this. However, if they fail to pay, it will negatively impact your credit score.
- One of the easiest loans to qualify for is a loan that you’ve already paid off. Getting a secured credit card with a cash-secured loan is ideal for those with lower credit scores. If for some reason you don’t pay your monthly bill, your cash deposit is used as a backup and your credit score will still reflect it as paid.
What About Personal Loans?
A personal loan is different from a loan for a car or home since it can be used for anything you need it for. Typically, personal loans have lower interest rates than credit cards, so people use them to pay off their credit card debt.
Positives:
While you will still owe money on your personal loan, your credit cards are being paid off and that will increase your credit score.
Negatives:
You must pay your personal loan off on time because this type of loan has a higher interest rate than home or car loans, due to the fact they don’t require any collateral.
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A high credit score will open the doors for more financial opportunities but while you’re waiting for those doors to open, you can make your dreams a reality by taking out a loan and being smart about paying it back. Remember, how much your loans affect your credit score, both the good and the bad is up to you.
If you have questions about your credit score, talk to a professional.
