How Do Loans Affect Your Credit Score?

Taking out a loan can have a significant impact on your credit score, both positively and negatively. Your credit score is one of the most important factors that lenders use to assess your creditworthiness and your ability to repay debt. Therefore, understanding how loans affect your credit score is essential for making informed decisions about borrowing.

Here’s how loans can influence your credit score:

1. Hard Inquiry (Credit Check)

When you apply for a loan, the lender typically performs a hard inquiry (also known as a hard pull) on your credit report to assess your creditworthiness. This means that the lender checks your credit history, including your current debt, payment history, and credit utilization.

Impact on credit score: A hard inquiry can cause a small, temporary dip in your credit score. Generally, the impact is minor, usually lowering your score by just a few points (typically 5–10 points). However, if you apply for several loans or credit accounts in a short period, the cumulative effect of multiple hard inquiries could be more significant.
Duration: Hard inquiries typically stay on your credit report for about two years, but their impact on your score decreases over time. After a few months, the effect on your credit score will become negligible.

2. Loan Amount and Credit Utilization

The loan amount you borrow plays a crucial role in how your credit score is affected, especially if the loan is unsecured (such as a personal loan) or a revolving line of credit (such as a credit card or a home equity line of credit).

Credit utilization: For revolving credit (such as credit cards or a credit line), the amount of credit you’re using relative to your available credit is known as credit utilization. A high credit utilization ratio (using a large percentage of your available credit) can lower your credit score. A personal loan doesn’t impact this metric directly, since it’s not revolving credit. However, if you take out a large loan and use it to pay off credit card debt, your credit utilization ratio may improve, which can positively impact your score.
Loan balances: If you take out a large loan, your total debt load will increase, which can affect your credit score. However, if you consistently make on-time payments and reduce the loan balance over time, this can improve your credit score in the long term.

3. Payment History

Your payment history is the most important factor affecting your credit score, accounting for about 35% of your FICO score. Making timely payments on your loan will have a positive effect on your credit score, while missed or late payments will negatively impact it.

On-time payments: When you make all of your loan payments on time, your credit score is likely to improve. Timely payments demonstrate to lenders that you are responsible and reliable with managing your debt, which can boost your score over time.
Late or missed payments: On the other hand, late payments, defaults, or missed payments can significantly lower your score. A single late payment can stay on your credit report for up to 7 years, making it harder for you to obtain favorable loan terms in the future.

4. Credit Mix

Lenders like to see that you can handle different types of credit responsibly, such as credit cards, mortgages, auto loans, and personal loans. This is known as credit mix, and it makes up around 10% of your FICO score.

Positive impact: Taking out a loan that adds variety to your credit mix (for example, an auto loan if you only have credit cards) can help improve your credit score, as long as you manage it well.
Negative impact: However, if you take out a loan that increases your overall debt without a clear plan for repayment, it could negatively impact your score by increasing your debt-to-income ratio.

5. Length of Credit History

Your length of credit history makes up 15% of your credit score, and it reflects how long you’ve had credit accounts open.

New loan impact: If you open a new loan, especially if it’s a long-term loan (such as a mortgage or auto loan), your average age of accounts will decrease. This might cause a slight dip in your credit score, but this effect is typically temporary.
Positive long-term impact: Over time, the loan can help improve your credit score, as long as you continue making payments on time. Keeping the loan open (even after it’s paid off) can help increase the overall length of your credit history, which may positively affect your score.

6. Debt-to-Income Ratio (DTI)

While not directly factored into your credit score, your debt-to-income ratio (DTI) plays a role in your overall financial health and can indirectly impact your credit score. DTI is the ratio of your monthly debt payments to your monthly income.

High DTI: If taking on a new loan increases your DTI, it could signal to lenders that you may struggle with future loan repayments. This could make it harder to get approved for new credit, and could even lead to higher interest rates. However, DTI doesn’t directly impact your credit score; it’s just a factor that lenders use to assess your ability to repay future debt.

7. Loan Payoff and Closing an Account

Paying off a loan early or closing a loan account can also have an impact on your credit score, although the effects are typically minor.

Paying off a loan: Once you pay off a loan in full, your credit report will show a “closed” account with a zero balance. This can have a positive impact on your credit score, as it reduces your overall debt load. However, if the loan was a significant part of your credit mix, its closure could lead to a slight dip in your score initially.
Closing a loan account: If you close an account after paying it off (e.g., a personal loan), it could reduce the average age of your accounts, which may lower your credit score. The impact is usually small and temporary, and it depends on the size of the loan and how many other accounts you have.

How to Minimize Negative Impacts and Maximize Positive Impacts on Your Credit Score

Here are a few strategies to ensure that your loan doesn’t harm your credit score:

Make Payments on Time: Timely payments are the most important factor for your credit score. Set up automatic payments to ensure you never miss a due date.
Avoid Opening Too Many Loans in a Short Period: Multiple hard inquiries in a short time frame can negatively impact your credit score. Only apply for loans you truly need and can manage.
Keep Your Credit Utilization Low: If you use a loan to pay down credit card debt, aim to keep your credit utilization below 30% to positively impact your score.
Consider the Impact of New Loans on Your Credit Mix: Before taking out a new loan, consider whether it will diversify your credit mix in a positive way and help your credit score in the long run.
Don’t Close Accounts Too Quickly: If you’ve paid off a loan, keep it open to maintain a longer credit history, unless the loan charges unnecessary fees.

Conclusion: How Loans Affect Your Credit Score

Loans can both positively and negatively affect your credit score, depending on how you manage them. Responsible use of loans, such as making on-time payments and keeping your credit utilization low, will typically improve your credit score. However, taking on too much debt or missing payments can have the opposite effect.

Before taking out a loan, it’s important to assess your ability to repay it and consider how it will impact your overall financial health and credit score. By managing loans wisely, you can use them to build a positive credit history and improve your credit score over time.