How Much Does a Loan Affect Your Credit Score?

A credit score is a three-digit number that predicts an individual’s creditworthiness, indicating how likely they are to repay borrowed money on time. Lenders use this score, typically ranging from 300 to 850, to decide on loan approvals, interest rates, and other credit terms. Taking out a loan influences this score, as its process and subsequent management directly contribute to the financial data used in its calculation.

Understanding Credit Score Components

Credit scores are calculated using information from credit reports, with models like FICO and VantageScore evaluating different data points. While specific calculations are proprietary, five major categories consistently influence credit scores.

Payment history is the most significant factor, accounting for approximately 35% of a FICO Score. This assesses whether past credit accounts have been paid consistently and on time, which indicates future repayment behavior.

The amount owed, or credit utilization, represents about 30% of a FICO Score. This factor considers the total debt carried across all accounts, focusing on the proportion of available revolving credit being used. A high utilization ratio can suggest overextension and a higher risk of missed payments. Conversely, keeping balances low relative to credit limits generally benefits the score.

Length of credit history contributes approximately 15% to a FICO Score. This component measures how long credit accounts have been open, including the age of the oldest and newest accounts, and the average age of all accounts. A longer history of responsible credit management generally indicates stability and reliability to lenders.

New credit, or recent credit activity, makes up about 10% of a FICO Score. This category considers how many new accounts have been opened recently and the number of hard inquiries on the credit report. Opening multiple new accounts in a short period can signal increased risk to lenders.

Credit mix accounts for the remaining 10% of a FICO Score. This factor evaluates the diversity of credit accounts, such as having a combination of revolving credit (like credit cards) and installment loans (like mortgages or auto loans). Demonstrating the ability to manage different types of credit responsibly is seen favorably by scoring models.

Initial Credit Score Impact of a New Loan

When a loan application is submitted, an immediate and temporary effect on a credit score often occurs. This initial impact stems primarily from a “hard inquiry” on the credit report. A hard inquiry happens when a lender checks an individual’s credit report to assess risk for a new loan or credit application. Each hard inquiry can cause a small, temporary dip in the credit score, typically around five points or less.

Hard inquiries remain on a credit report for up to two years, though their influence on the credit score usually diminishes after 12 months. While a single inquiry has minimal impact, multiple hard inquiries in a short timeframe can accumulate and suggest higher risk to lenders. However, for specific types of loans, such as mortgages or auto loans, multiple inquiries made within a focused period, generally 14 to 45 days, are often treated as a single inquiry to allow for rate shopping.

The opening of a new loan account also affects the average age of all credit accounts. Adding a new, young account can lower the overall average age of the credit history. This effect is generally more pronounced for individuals with a shorter overall credit history, as the new account represents a larger proportion of their total accounts. This initial dip is typically short-lived and often recovers with responsible loan management.

Ongoing Credit Score Impact from Loan Management

The most substantial and enduring influence a loan has on a credit score comes from its ongoing management, particularly payment history. Making consistent, on-time payments is the most impactful action for positive credit score development. Payment history accounts for 35% of a FICO Score, directly demonstrating a borrower’s reliability to repay debts as agreed.

Conversely, late or missed payments can significantly damage a credit score. A payment reported as 30 days or more overdue can cause a substantial drop in the score, and the negative impact intensifies with greater delinquency, frequency, or severity. Such derogatory marks can remain on a credit report for up to seven years, though their impact lessens over time. Consistent on-time payments, even after a missed one, can help mitigate the long-term negative effects.

The reduction of the loan balance, especially for installment loans, also positively impacts the “amounts owed” component of the credit score. As the principal balance of an installment loan decreases over time, the ratio of the outstanding balance to the original loan amount improves. This demonstrates a borrower’s ability and willingness to manage and repay debt, which is viewed favorably by credit scoring models.

Even after a loan is paid off, its positive payment history continues to benefit the credit score for many years, typically up to 10 years. Paying off an installment loan, particularly if it was the only one or an older account, can sometimes lead to a temporary, small dip in the score. This occurs because the credit mix might become less diverse or the average age of accounts could decrease if other accounts are newer.

How Loan Types Influence Your Credit Score

Different types of loans contribute uniquely to a credit score, primarily through their role in an individual’s credit mix. Credit mix accounts for 10% of a FICO Score, referring to the diversity of credit accounts an individual manages. This includes both revolving credit, like credit cards, and installment loans, such as mortgages, auto loans, or personal loans. Demonstrating responsible management of both types of credit can positively influence a score, as it shows versatility in handling various financial obligations.

Installment loans, which involve fixed payments over a set period, are generally viewed as less risky than revolving credit. This is partly because installment loans, particularly secured ones like mortgages or auto loans, are often backed by an asset. The collateral reduces the lender’s risk, and the predictable payment schedule allows for consistent on-time payments, which are beneficial for the payment history component of the score.

Unsecured personal loans, while not backed by collateral, still offer the advantage of a fixed repayment schedule, contributing to a stable credit profile if managed well.

The presence of an installment loan can also indirectly benefit the “amounts owed” category. While installment loan balances do not factor into the credit utilization ratio in the same way revolving credit does, paying down these loans reduces overall debt. This can improve the ratio of the current balance to the original loan amount.