How Do Loans Affect Your Credit Score?

A credit score is a numerical representation of an individual’s creditworthiness, indicating the likelihood of repaying a loan on time. Lenders use these scores to assess risk, influencing decisions on loan approvals, interest rates, and credit limits. This score is primarily derived from information in credit reports, which document an individual’s credit history.

How Loan Applications Affect Your Score

Applying for a loan typically triggers a “hard inquiry” on your credit report when a lender requests it. A hard inquiry can cause a small, temporary dip in your credit score, often by fewer than five points. These inquiries remain on your credit report for up to two years, though their impact usually diminishes after 12 months.

When you are shopping for a specific type of loan, such as a mortgage, auto loan, or student loan, multiple inquiries within a concentrated timeframe are often treated as a single event by credit scoring models. This allows consumers to compare interest rates and terms without multiple negative impacts on their score. The typical timeframe for this “rate shopping” period can range from 14 to 45 days, depending on the scoring model.

In contrast to hard inquiries, a “soft inquiry” does not affect your credit score. These occur when you check your own credit report, or when a potential lender or employer reviews your credit for pre-approval offers or background checks.

How Opening a New Loan Affects Your Score

Opening a new loan account can immediately impact your credit score. Credit scoring models consider the average age of your credit accounts. A new loan can decrease this average age, potentially leading to a slight, temporary dip, especially with a short credit history.

A new loan also adds to your total amount of debt, which is another element in credit scoring calculations. While acquiring new debt might initially seem unfavorable, credit scoring models assess the overall debt burden in relation to your ability to manage it. The total amount owed accounts for a significant portion of your score, around 30% in some models.

Adding an installment loan, such as a mortgage, auto loan, or personal loan, can positively contribute to your “credit mix.” Lenders prefer to see that you can responsibly manage different types of credit, including both revolving accounts like credit cards and installment accounts. This diversification demonstrates a broader ability to handle various financial obligations, which can be beneficial over time.

How Managing and Repaying a Loan Affects Your Score

Your payment history is the most significant factor in determining your credit score, often accounting for 35% to 40% of the score. Consistently making on-time payments on your loan builds a strong positive payment history, which is crucial for improving and maintaining a healthy credit score.

Conversely, late or missed payments can severely damage your credit score. A payment reported 30 days or more past due can cause a significant drop in your score, with the negative impact increasing the longer the payment is delayed. These negative marks can remain on your credit report for up to seven years, although their impact lessens over time if you re-establish a pattern of timely payments. Defaulting on a loan or having an account sent to collections has even more severe and lasting negative consequences.

As the balance of an installment loan declines with regular payments, this can be viewed favorably by scoring models. It indicates a reduction in your overall debt burden and a commitment to fulfilling your financial obligations. Paying off a loan completely marks the successful completion of the account, which contributes positively to your credit history length and demonstrates responsible credit management. While paying off a loan might sometimes cause a temporary, slight dip in score due to changes in credit mix or average account age, the long-term benefit of a completed, on-time repayment history is generally positive.

Different Loan Types and Their Specific Credit Impacts

Installment loans, such as mortgages, auto loans, student loans, and personal loans, involve borrowing a fixed sum of money repaid over a set period through regular, fixed payments. The predictable nature of these payments and their clear repayment schedules contribute to building a stable credit history.

Revolving credit, like credit cards, differs from installment loans because it provides a continuous line of credit that can be used repeatedly up to a certain limit. With revolving credit, the balance can fluctuate, and minimum payments are typically required, but there isn’t a fixed end date for repayment. Credit scoring models evaluate revolving credit based on factors like credit utilization, which is the amount of credit used compared to the total available credit. Keeping utilization low, ideally below 30%, is beneficial for scores.

Secured loans, such as mortgages or auto loans, require collateral like a house or car, which reduces the lender’s risk. This collateral can make it easier to qualify for a loan and may result in lower interest rates, even for individuals with lower credit scores. Unsecured loans, including most personal loans and student loans, do not require collateral, meaning approval relies more heavily on your creditworthiness and income. Unsecured loans often have stricter eligibility requirements and higher interest rates due to the increased risk for lenders. Defaulting on a secured loan carries the additional risk of losing the pledged asset.