Does Taking Out a Loan Hurt Your Credit?

Taking out a loan can either positively or negatively impact your credit score, depending on how you manage it. At first glance, many people assume that borrowing money will only hurt their credit score. But the reality is far more nuanced. There are various factors involved in how your credit score changes once you take out a loan. While the immediate impact might show a slight dip in your score, the long-term consequences are based on how responsibly you manage that debt.

What happens to your credit score when you apply for a loan?
Before we dive into how the actual loan impacts your credit, it's important to understand that the process of applying for a loan itself has implications. When you apply for a loan, lenders perform a "hard inquiry" on your credit report. This inquiry is recorded and could slightly lower your credit score for a short period, usually no more than a few points. Hard inquiries stay on your credit report for two years, but their effect on your score diminishes over time.

However, if you're rate-shopping for a mortgage, student loan, or auto loan, multiple inquiries within a short period (usually 14 to 45 days, depending on the credit scoring model) are generally counted as one inquiry, minimizing the potential damage to your score. This encourages borrowers to shop around for the best rates without penalizing them for doing so.

How much can your credit score drop?
The impact of a hard inquiry is relatively minor. FICO, one of the main credit scoring models, suggests that a single inquiry will usually drop your score by less than five points. However, the effect can vary depending on the borrower’s credit profile. For instance, if you have an excellent credit score and a lengthy credit history, the drop will likely be insignificant. On the other hand, if you have a shorter credit history or a lower score, the impact might be more noticeable.

It's important to remember that hard inquiries only account for about 10% of your total credit score, so while they are something to be aware of, they're not the most significant factor affecting your credit.

The loan itself: A double-edged sword?
Once the loan is approved, it’s added to your credit report as a new account. Having a mix of different types of credit accounts (such as credit cards, car loans, and mortgages) can improve your credit score, as credit mix accounts for about 10% of your score. Adding an installment loan to your mix could be beneficial if you primarily have revolving credit, like credit cards.

On the flip side, the new loan increases your total debt load, which might lower your score in the short term. This is especially relevant if the loan significantly adds to your overall debt relative to your income.

How loan repayments impact your credit score?
One of the most critical aspects of your credit score is your payment history, which makes up about 35% of your FICO score. Timely repayment of the loan can significantly boost your credit score over time. The longer you make on-time payments, the more positive your payment history will be. Every on-time payment adds to your record of responsible borrowing, proving that you can manage debt effectively.

However, if you miss payments or default on the loan, the consequences for your credit score can be severe. Late payments can stay on your credit report for up to seven years, and they can lower your score significantly.

Loan amounts and credit utilization
Your credit utilization ratio (the amount of credit you’re using versus the amount of credit available to you) plays a major role in your credit score, accounting for about 30%. For revolving credit like credit cards, it’s generally recommended to keep this ratio below 30%. However, installment loans like personal loans or car loans aren’t typically included in credit utilization calculations. That said, taking out a large loan could still hurt your score if it increases your debt-to-income ratio to an extent that makes you appear riskier to future lenders.

Loan term: Long-term commitment, long-term effects
The length of your credit history accounts for about 15% of your credit score. Taking out a loan, especially a long-term one like a mortgage, can be a boon for your score if you manage it well over time. But if you close the loan too quickly, by paying it off early, you might inadvertently shorten your credit history and reduce its positive impact on your score. This doesn’t mean you should avoid paying off loans early—it just means that you should be aware of the potential effects on your credit score.

Debt consolidation and refinancing: When loans help your credit
In some cases, taking out a loan can directly help improve your credit score. If you take out a personal loan to consolidate high-interest credit card debt, for example, you might be able to pay off your credit card balances in full. This can reduce your credit utilization ratio, which could result in a boost to your credit score.

Additionally, refinancing existing loans can sometimes lower your interest rates, making the debt easier to manage and reducing the chances of missed payments. As long as you continue to make payments on time, your credit score can improve as a result of better loan terms and reduced financial stress.

The balance between risk and reward
While taking out a loan can carry some immediate risks for your credit score—mainly in the form of hard inquiries and increased debt load—the long-term benefits can outweigh the short-term impacts. By making timely payments, you can improve your payment history, diversify your credit mix, and build a positive credit profile that will serve you well in the future.

Key takeaways for responsible loan management

• Be mindful of how often you apply for credit. Too many hard inquiries in a short period can hurt your score.
• Use loans strategically to build credit by making timely payments.
• Consider the long-term impact of a loan on your credit mix and history.
• Monitor your debt-to-income ratio, even though it’s not directly part of your credit score.
• If you’re consolidating debt with a loan, aim to reduce your overall credit utilization.

By understanding the factors that affect your credit score when taking out a loan, you can make informed decisions that strengthen your credit profile over time.