Does Applying for a Loan Hurt Your Credit Score?

A credit score is a numerical representation of an individual’s creditworthiness, typically a three-digit number ranging from 300 to 850. Lenders use this score to assess the likelihood of a borrower repaying a loan and making timely payments. It acts as a quick indicator of financial responsibility, influencing decisions on loan approvals, interest rates, and other credit terms. Understanding how applying for a loan can influence this score is important for navigating personal finance.

Understanding Credit Scores and Their Purpose

Credit scores are calculated based on information within a credit report, which details a consumer’s credit history. Two widely used scoring models are FICO and VantageScore, both of which consider several key components. Payment history, demonstrating consistent on-time payments, is the most influential factor, accounting for about 35% of a FICO score.

Amounts owed, specifically credit utilization (the percentage of available credit being used), is another significant factor, making up around 30% of a FICO score. Lower utilization rates indicate a lower risk to lenders. The length of one’s credit history, including the age of the oldest account and the average age of all accounts, also contributes to the score, around 15%.

New credit, reflecting recent applications for credit and newly opened accounts, impacts the score by about 10%. A healthy credit mix, showing a borrower’s ability to manage different types of credit like installment loans and revolving credit, accounts for about 10% of the score. Higher scores lead to more favorable loan terms and lower interest rates.

The Role of Credit Inquiries (Hard vs. Soft)

Understanding the distinction between hard and soft credit inquiries is important, as they have different impacts on a credit score. A hard inquiry, also known as a “hard pull,” occurs when a lender formally checks a credit report after a consumer applies for new credit, such as a mortgage, auto loan, personal loan, or credit card. This type of inquiry indicates to other potential lenders that an individual is seeking new debt. Hard inquiries can remain on a credit report for up to two years, though their impact on credit scores diminishes after 12 months.

A single hard inquiry results in a small, temporary dip in a credit score, by fewer than five points. However, multiple hard inquiries in a short period could signal increased risk to lenders, potentially leading to a more noticeable, albeit still temporary, score reduction. This temporary impact recovers within a few months to a year with responsible credit behavior.

Conversely, a soft inquiry does not affect a credit score. Soft inquiries occur when an individual checks their own credit score or report, or when a lender pre-qualifies or pre-approves an individual for an offer without a formal application. These checks are not tied to a specific credit application and are used for informational purposes. While soft inquiries may appear on a credit report, they are not factored into credit scoring models.

New Credit Accounts and Your Score

Opening a new loan account can influence a credit score. One significant impact is on the average age of accounts. When a new account is opened, it can lower the overall average age of all credit accounts. Credit scoring models view a longer credit history more favorably, as it provides a more extensive track record of financial management.

A new loan also affects the amounts owed, specifically credit utilization for revolving credit. While installment loans have fixed payment schedules, opening a new credit card or line of credit increases total available credit. If balances on existing revolving accounts remain the same or decrease, this positively impacts the credit utilization ratio. Conversely, if the new account leads to increased overall debt, it negatively affects the score.

A new loan influences the credit mix component of a score. If the new account introduces a different type of credit, such as an installment loan when a consumer primarily has revolving credit, it demonstrates an ability to manage various forms of debt. This diversification is viewed positively by scoring models. However, it is not advisable to open new accounts solely to improve credit mix, as the benefits are minor compared to other factors like payment history.

Impact of Different Loan Types on Your Score

The type of loan applied for and opened affects a credit score. Installment loans, such as mortgages, auto loans, or personal loans, involve a fixed amount of money borrowed and repaid over a set period with regular, predetermined payments. Once opened, these loans contribute to the credit mix and, with consistent on-time payments, build a positive payment history, which is the most influential factor in credit scoring. They are considered less risky by scoring agencies than revolving credit.

Revolving credit, like credit cards, offers a credit limit that can be used, repaid, and reused. Its primary ongoing impact on a score relates to credit utilization. High utilization rates on revolving accounts (above 30% of the available credit) significantly lower a score, while keeping balances low is beneficial. Revolving credit has a larger impact on scores, both positively and negatively, depending on how responsibly it is managed.

Multiple Loan Applications and Score Aggregation

When a consumer applies for multiple loans of the same type within a concentrated period, credit scoring models employ a mechanism called “aggregation” or “rate shopping” to minimize undue negative impact. Instead of each application triggering a separate hard inquiry that lowers the score, multiple inquiries for the same purpose are counted as a single event. This feature acknowledges that consumers compare loan terms from various lenders to secure the most favorable rates.

The timeframe for this aggregation varies depending on the credit scoring model. FICO scores group inquiries for mortgages, auto loans, and student loans made within a 45-day window as one inquiry. VantageScore models aggregate inquiries within a 14-day period.

This aggregation prevents a consumer’s score from being disproportionately penalized for responsible rate shopping. For example, applying to several mortgage lenders within a 45-day period results in only one hard inquiry affecting the score. This aggregation applies to installment loans and not to revolving credit applications like credit cards, where multiple applications in a short time frame are viewed as higher risk and each inquiry may count individually. Strategic timing of loan applications is beneficial when seeking certain types of credit.