Does applying for a loan hurt your credit score?
When you apply for debt products, your credit score may go down a bit. Personal loans are no exception to the rule – applying in hopes of getting approved for the funds you need can lower your credit score.
But there’s an upside: Making monthly payments on time can also mean good news for your credit score over time. Your payment history, which is the largest component of your credit score, will improve. Your credit utilization will decrease, which also benefits your overall credit health.
How loan applications affect your credit
When you apply for a personal loan, the lender will determine your credit risk or creditworthiness by evaluating your credit score and history. To do this, lenders run a rigorous credit check. When they run these checks, they’re looking for indicators of financial health like low credit balances and a good debt-to-income ratio.
A hard credit check temporarily lowers your credit score by five points or less. If you have excellent credit, your score will drop less. Your credit score will usually recover within a few months, but a hard credit check will stay on your credit report for up to two years.
Since applying for a personal loan requires a rigorous credit check, it’s a good idea to be as prepared as possible. When you apply for a personal loan you are required to submit additional documents. This usually includes proof of identity, employer and income verification, and proof of address.
Related: Best Home Loan Interest Rate of all Banks 2022
How a personal loan can help your credit
Under the right circumstances and when used responsibly, personal loans can positively impact your credit score in several ways:
- Better credit mix: Adding a variety of credit to your portfolio helps keep your credit score high as long as you stay on top of payments. It is usually a good idea to have a mix of installment loans and revolving credit.
- Debt Consolidation: If you use a personal loan to consolidate debt, you can take advantage of lower interest rates than you would normally get with credit cards. With a lower interest rate, you’ll be able to pay off outstanding debt faster, which will improve your credit score.
- Payment History: A personal loan can help establish a positive payment history when done in full and on time. Positive payment history makes up 35 percent of your FICO score, the largest category in determining your score.
- Reduced credit utilization ratio: Personal loans don’t affect your credit utilization ratio, but using that loan to pay off revolving credit card debt can lower your ratio. You generally want to keep your credit utilization below 30 percent.
How Personal Loans Can Hurt Your Credit
While a personal loan can help you improve your credit score, it can also hurt your score if you are unwilling to repay it. There are some risks you need to consider before applying for a personal loan:
- A hard inquiry on your credit: Due to a hard credit check, you may see a short-term drop in your credit score when you formally apply for a loan. While this may not be harmful to your long-term credit score, it can hurt your credit a bit if you apply for multiple loans in a short period of time.
- Monthly Payments: Before applying for a loan, you should analyze your monthly expenses to see if it is in your budget to add another monthly payment to your expenses.
- More debt: Every time you borrow money, you increase your chances of falling into debt—especially if you keep racking up credit card balances while paying off your loans. While not all debt is necessarily negative, it is important to analyze your current financial situation before applying to determine if a loan is a move in the right direction.
- Potentially high interest rates and fees: Depending on your creditworthiness, you could be stuck with significantly higher interest rates and fees. The higher the interest rate, the longer you can repay the loan. If you can’t afford those rates over the long term, you risk falling behind on payments and damaging your credit score.
hWhat does a loan application ave to do with my credit score?
Lenders use credit scores to assess your creditworthiness: Can they trust you to pay back a loan (or rent an apartment, or pay your phone bill, etc.)?
Doing things that could be considered risky, such as carrying high balances on your credit cards or missing payments, will lower your score. So why would a new app be considered dangerous?
It’s all numbers and probability. Statistically, people with more credit inquiries are more likely to declare bankruptcy, which means creditors risk losing their money, according to FICO, a widely used credit score. So credit inquiries, especially too many credit inquiries, can be a red flag.
However, rate shopping for student loans, mortgages and auto financing that can result in multiple inquiries are treated a little differently.
In those cases, you have a window of time (14 to 45 days, depending on the scoring model) during which you can apply for several of those loans and have the same impact on your score as applying for one. This is because lenders expect you to compare rates for those loans, and scoring models don’t punish you for being financially savvy.
How can I reduce hard inquiries?
If you need a loan, there’s probably no way to avoid a tough inquiry. But the score gains you get from paying on time will outweigh the short-term point loss from applications.
What you want to avoid is applying and getting rejected. Then you may still need a loan, but your credit score will be lower.
Here’s how to make the most of the app:
- Be as certain as possible that you meet the qualifications and will be approved. Some lenders offer pre-qualification, which usually doesn’t involve a hard inquiry and can help you determine whether you’re likely to qualify.
- Before you apply, check the terms and make sure the loan is right for you.
- avoid applying for new credit for at least six months before you plan to make a major purchase that requires a home or car loan.
Why it’s smart to check your own credit
While doing a credit check when you apply for credit can lower your score, doing your own credit check has no effect on your score.
It’s completely safe, and it’s a great way to know in advance what a lender will look for and whether you’re likely to qualify.
What to keep in mind before taking a personal loan
Before taking out a loan, consider the pros and cons of adding another monthly bill to your budget. Some things to think about are:
- Reason for Loan: Are you interested in a personal loan to pay for a vacation or luxury item? If this is the case, consider whether saving for the item makes more sense than applying for a loan. Depending on the purpose of your loan, you can also consider other types of loans. If you are taking a loan for home improvement purposes, home equity loans may have better rates and may suit your needs better.
- Your Credit Score and History: Do you have a good credit score and healthy habits with your credit? If not, you can take steps to improve your credit score by reinstating some of those bad habits.
- Your debt-to-income ratio: Your debt-to-income ratio, or DTI, measures your monthly debt compared to your monthly income. Generally, the higher the DTI ratio, the less likely you are to qualify for a loan. To calculate your DTI ratio, you can use Bankrate’s debt-to-income ratio calculator.
- All Your Options: Shopping for the best personal loan for you is one of the most important steps. Each lender offers different rates, fees and terms. The best way to find out how much you will pay each month is to explore all of your options.
Bottom line
A personal loan can be a great tool to help you improve your credit score, consolidate credit card debt, or pay off major expenses. However, it is important to know how applying for a loan can affect your credit score. While you may experience a short-term drop when you submit your application, you can improve your credit score in the long run by making timely payments and using your loan funds to pay off existing debt.
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