You probably already know that credit scores are crucial for your financial health, influencing loan approvals, interest rates, and even insurance premiums. But here's something you might not be so sure about: Does applying for a loan affect credit scores? It's a common concern—and we have the answer.
In this article we’ll break down everything you need to know about how loan applications can influence your credit score. Whether you're looking to buy a home, consolidate debt, or make a significant purchase, keep reading to learn more.
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Can applying for loans hurt your credit score?
Short answer: yes, applying for a loan can affect your credit score. However, the impact depends on the type of credit check conducted during the application process. Lenders typically perform either a soft credit check or a hard credit check to assess your creditworthiness. Let’s understand the difference between them.
Soft credit checks
A soft credit check, also known as a soft inquiry, happens when a lender or creditor reviews your credit report as part of a background check or pre-approval process. These checks are frequently used for promotional offers or employer background checks.
The key point is that soft inquiries don’t have a negative impact on your credit score. You can check your own credit report without any negative consequences, and lenders can also perform soft checks without affecting your score.
Hard credit checks
A hard credit check, or hard inquiry, happens when you apply for credit, such as a loan, mortgage, or credit card. It’s a more in-depth examination of your credit history, including past loans, credit card usage, and payment patterns. This type of inquiry is recorded on your credit report and can temporarily lower your credit score.
Most lenders will start with a soft credit check to certify you’re eligible, but they’ll do a hard inquiry later in the process as a final check.
“The best way to avoid hurting your credit score is to talk to the lender about their credit check process,” says Joe Camberato, CEO of National Business Capital, a national lending marketplace. “This way, you’ll know when your credit score might be affected.”
How or when loans can hurt your credit?
Taking out a loan can have negative effects on your credit score if not managed properly. Here are some ways loans can hurt your credit:
Late or missed payments
One of the most significant factors in your credit score is your payment history. Missing loan payments or making late payments can severely damage your credit score. Lenders report late payments to credit bureaus, and these marks can stay on your credit report for up to seven years.
That’s why it is so important to be cautious before applying for a loan. “A common mistake people make is going for loans they can't realistically repay,” says Michael Schmied, financial analyst at Kredite Schweiz. “For example, if you're making $3,000 a month, don't take a loan that requires $2,000 monthly payments. It's just not sustainable.
“Missing payments can drop your score by as much as 100 points—be honest about what you can handle,” Schweiz says.
High credit utilization ratio
Your credit utilization ratio (which is the amount of credit you're using compared to your total available credit) also plays a crucial role in your credit score. Taking out a large loan can increase your credit utilization ratio, especially if you use the loan to pay off credit card debt and then continue to carry high balances on your cards.
“One way to apply for a loan without hurting your score is to keep your credit utilization ratio low—below 30%. If your credit limit is $10,000, try to keep your balance under $3,000,” Schmied says. “Pay down as much as you can before applying, and don't close old accounts—they help your credit history.”
Multiple hard inquiries
Each time you apply for a loan, a hard inquiry is added to your credit report. Typically, a single hard inquiry may lower your score by a few points, but multiple inquiries in a short period can have a cumulative and bigger effect. According to Schmied, lenders may see multiple loan requests as a sign of desperation.
However, credit scoring models often treat multiple inquiries for the same type of loan (e.g., mortgage, auto loan) within a short period as a single inquiry to allow for rate shopping.
High debt levels
If you already have a significant amount of debt, taking out additional loans can exacerbate the problem. High debt levels can make it difficult to manage your finances and keep up with payments, leading to a higher risk of damage to your credit score. (For advice on how to become debt-free, read this.)
How or when loans can help you build your credit
On the other hand, loans can also have positive effects on your credit score when managed responsibly.
Establishing a credit history
If you have a limited or nonexistent credit history, taking out a loan and making timely payments can help you establish a credit history. Lenders like to see you have experience managing different types of credit accounts responsibly.
Diversifying your credit mix
Your credit mix, or the variety of credit accounts you have, is another factor that influences your credit score. Having a diverse mix of credit accounts, such as installment loans (e.g., auto loans, personal loans) and credit cards, can positively impact your score. Taking out a loan adds to this mix and shows that you can handle different types of credit.
Building a positive payment history
Consistently making on-time payments on your loan can significantly boost your credit score. A solid payment history shows lenders you are a reliable borrower, which can improve your chances of being approved for credit in the future.
Reducing the credit utilization ratio
If you use a loan to pay off high-interest credit card debt, you can lower your credit utilization ratio (remember, 30% is a very good mark). This can positively impact your credit score, as a lower credit utilization ratio proves you are not overly reliant on credit.
Things to consider before taking a loan
Loans can be a valuable tool for financing various needs, from education and major purchases to debt consolidation and business ventures. However, it's important to consider it carefully and make informed decisions. Take these steps before taking on a loan:
Assess your financial situation
Carefully analyze your income sources and monthly expenses. Can you comfortably afford the loan repayments without compromising your essential financial obligations? To evaluate that use the debt-to-income ratio and compare your total monthly debt payments (current and future) to your gross monthly income. A high ratio indicates a significant debt load, which isn’t prudent.
Bonus tip: Having a healthy savings buffer can give you a safety net for unexpected expenses and ensure you don't fall behind on loan repayments.
Understand loan terms and conditions
Read the loan agreement thoroughly to avoid surprises down the road. Anything that seems too good to be true should raise a red flag.
“If you’re getting similar offers from several lenders and then one suddenly offers you a much larger amount, lower interest, and longer repayment terms without a clear reason, be cautious,” Camberato says. “There might be hidden terms in the contract that make it more expensive or restrictive, or the lender could be trying to lure you in with attractive terms only to change them later on.”
Another big red flag, warns Schmied, is when lenders offer very short repayment terms. “This can mean sky-high monthly payments that you might struggle to afford,” he says “Imagine you take a loan with a 12-month term, but your monthly payment is $1,000—it's a recipe for stress.”
Consider alternative financing options
Sometimes, alternative methods might be more cost-effective and less risky. For educational expenses, for example, explore scholarship and grant opportunities that can reduce your reliance on loans.
“Loans like FHA or VA loans can be a good option if your credit isn't perfect. These loans often have better terms and lower down payment requirements—sometimes as low as 3.5%,” Schmied says. “Credit unions and community banks can also be more flexible. Explore these options to find a lender who gets your situation.”
In some cases, borrowing from family or friends with clear terms and agreements can be a viable option. (But if you've already taken out a student loan, here's how to pay it off fast.)
Plan for repayment
Create a budget that incorporates the loan repayment amount and ensure you have sufficient funds allocated each month. Develop a plan to handle unexpected financial situations that might impact your ability to make loan repayments. Planning ahead can help you avoid late fees and negative marks on your credit report.
Improve creditworthiness
A few strategies can help individuals with low credit scores improve their creditworthiness and qualify for better loan terms. However, according to Camberato, there’s no quick fix: “If you’re planning to apply for a loan, spend the time beforehand lowering balances, disputing any errors, and establishing a history of on-time payments. The more time you have to do this, the better.”
Schmied offers other ways to improve creditworthiness: “If your credit score is low, consider a secured credit card to rebuild it. Also, don't open multiple new accounts at once—that can drop your score. When you're ready to apply for a loan, show lenders your improved habits to get better terms.”
FAQs
Does my credit score go down when I apply for a loan?
Applying for a loan can cause a small, temporary decrease (around 5 points or less) in your credit score due to the hard inquiry made by the lender. However, if you manage your new loan responsibly by making timely payments, it can positively impact your credit score in the long run.
Does applying for a car loan affect credit?
Yes, applying for a car loan results in a hard inquiry on your credit report, which can slightly lower your credit score temporarily. The impact is usually around five points.
Do multiple mortgage applications hurt credit?
Multiple mortgage applications can temporarily lower your credit score due to hard inquiries from lenders. However, if these inquiries occur within a short period, typically 14-45 days, credit scoring models like FICO and VantageScore treat them as a single inquiry to allow rate shopping for the best mortgage terms.
How long does applying for a loan affect credit?
A hard inquiry from applying for a loan typically affects your credit score for about 12 months. However, the check will remain on your credit report for two years. The overall impact of a hard inquiry is reduced over time, especially if you keep good credit habits.
Can I apply for a loan without affecting my credit score?
Yes, you can apply for a loan without affecting your credit score by opting for lenders that do soft credit checks instead of hard inquiries. Soft inquiries don’t impact your credit score and can give you pre-approval or initial loan offers. However, keep in mind that final loan approval will typically require a hard inquiry, which can slightly affect your credit score. Always ask the lender about their inquiry process before applying.