Does Borrowing Money Affect Credit Score?

A credit score serves as a numerical summary of an individual’s creditworthiness, typically ranging from 300 to 850. Lenders utilize this three-digit number to assess the likelihood of a borrower repaying a loan on time. Borrowing money is an integral part of personal finance, and the way credit is managed directly influences this score. This article explores the intricate relationship between borrowing activities and credit health.

How Borrowing Influences Credit Score Components

Borrowing activities directly affect several key components that determine one’s credit score. Payment history, which accounts for approximately 35% of a FICO Score, is the most impactful factor. Consistently making payments on time demonstrates financial responsibility and positively contributes to a strong credit profile. Conversely, late payments, even those 30 days past due, can significantly harm a score and remain on a credit report for up to seven years.

Credit utilization, representing about 30% of a FICO Score, measures the amount of revolving credit currently used compared to the total available credit. Maintaining a low utilization ratio, generally below 30% across all revolving accounts, is beneficial for credit scores. A high utilization rate can signal an increased risk of overextension to lenders, potentially leading to a lower score. This ratio is calculated by dividing total credit card balances by total credit limits.

The length of credit history, accounting for around 15% of a FICO Score, considers the age of the oldest account, the newest account, and the average age of all accounts. A longer history of responsible credit management results in a higher score. Opening new accounts can decrease the average age of one’s credit history, which might temporarily lower a score.

New credit, comprising about 10% of a FICO Score, refers to recently opened accounts and inquiries from lenders. Each time an individual applies for new credit, a hard inquiry is placed on their credit report, causing a small, temporary dip in their score. Opening multiple new accounts in a short period can be viewed as a higher risk by lenders.

Credit mix, which makes up about 10% of a FICO Score, evaluates the diversity of credit accounts an individual manages. This includes both revolving credit, like credit cards, and installment loans, such as mortgages or auto loans. Demonstrating the ability to responsibly handle different types of credit can show lenders a broader range of financial management experience.

Different Types of Borrowing and Their Impact

The specific type of borrowing significantly influences how credit scores are affected. Revolving credit, which includes credit cards and lines of credit, allows borrowers to continuously use and repay funds up to a set limit. Payments on revolving accounts can vary based on the outstanding balance, and continuous management of these accounts directly impacts credit utilization.

Installment loans, such as mortgages, auto loans, student loans, and personal loans, involve borrowing a fixed sum that is repaid through regular, predetermined payments over a set period. The predictable payment schedule of installment loans allows individuals to demonstrate consistent repayment ability. While less influential on scores than revolving credit, successful repayment of installment loans contributes positively to one’s credit history and credit mix.

A diverse credit mix, incorporating both revolving and installment accounts, can be beneficial for a credit score. This diversity signals to lenders that an individual can responsibly manage various forms of debt. However, it is not advisable to open new accounts solely to diversify credit types, as the immediate impact of new inquiries and reduced average account age can outweigh the benefits.

Strategies for Responsible Borrowing

Managing borrowing responsibly is crucial for maintaining and improving one’s credit score. Making all payments on time is a primary factor, as payment history carries significant weight in credit scoring models. Setting up automatic payments or reminders can help ensure that due dates are never missed.

Keeping credit utilization low on revolving accounts is another effective strategy. Aiming to use no more than 30% of available credit, and ideally even less, demonstrates responsible credit management. Regularly paying down balances, possibly even multiple times within a billing cycle, can help maintain a low utilization ratio.

Individuals should avoid opening too many new credit accounts simultaneously. Each new application results in a hard inquiry on the credit report, which can temporarily lower a score. While a new account might increase overall available credit, the short-term impact of multiple inquiries or a reduced average account age can be detrimental. Applying for new credit only when genuinely needed and with a clear repayment plan is a prudent approach.

Maintaining a healthy credit mix over time can also be advantageous. This involves responsibly managing a combination of revolving accounts and installment loans. Regularly monitoring credit reports, which can be obtained for free annually from each of the three major credit bureaus under the Fair Credit Reporting Act (FCRA), allows individuals to check for accuracy and identify any potential issues.