A loan is money that one person (the lender) gives to another person (the borrower) with a promise that a repayment will be made within a certain time period. When you take out a loan, you typically sign a contract agreeing to make a certain number of payments for a certain amount of money to be paid by a specific date each month.
In a broad sense, credit represents the trust or belief that you’ll repay the money you borrow. You’re said to have good credit when lenders believe you’ll repay your debts (and other financial obligations) on time. Bad credit, on the other hand, implies that it's not likely you will pay your bills to the creditor on time. Your credit is based on how you've handled your previous debt obligations. If you've historically paid on time, lenders have more trust that you'll continue to do so.
Your payments on a loan (and even undertaking the loan itself) have an impact on your credit—more specifically, your credit score, which is a numeric snapshot of your credit history at a given point in time.
Loan Applications Impact Your Credit
Did you know that just applying for a loan can lower your credit score, even if it's only by a few points? That’s because about 10% of your credit score comes from the number of credit applications you make.
Each time you apply for credit, an inquiry is placed on your credit report showing that a business has reviewed your credit history. Several inquiries, especially in a short period of time, may indicate that you are in desperate need of a loan or that you’re taking on more loan debt than you can handle—neither of which is good for your credit score.
If you’re shopping around for a mortgage loan or auto loan, you have a grace period during which multiple loan inquiries won't each have an effect on your credit score. Even after you’ve finished your rate shopping, the loan inquiries are treated as a single application rather than several. That window of time is between 14 and 45 days, depending on which credit score the lender checking your score is using. Therefore, you should aim to keep your loan shopping within a small frame of time to lessen the impact on your credit score.
Timely Loan Payments Raise Credit Scores
Once you're approved for a loan, it's important that you make your monthly payments on time. Your loan payments will have a significant impact on your credit. Because payment history is 35% of your credit score, making payments on time is essential to building a good credit score. Even a single missed payment can hurt your score. Timely loan payments will give you a good credit score—and make you a more attractive borrower—while late loan payments will flag you as a high-risk borrower.
Because of penalties and interest, missing a loan payment can quickly snowball into more late payments. This road can ultimately lead to a serious issue such as repossession of your car or foreclosure on your home. These are not only serious difficulties, but also damage your credit even further.
High Loan Balances May Harm Credit
The balance of your installment loan also influences your credit. You’ll gain credit score points as you pay your balance down, because creditors will see this as a sign that you will reliably pay off your debt. The larger the gap between your original loan amount and your current loan balance, the better your credit score will be.
Your Loan and Your Debt-to-Income Ratio
Your loan payment comprises part of your debt-to-income ratio, which is a measure of the amount of your income that you spend on debt payments. For example, a person making $5,000 per month with loan payments totaling $1,500 per month would have a debt-to-income ratio of $30%.
What's the ideal debt-to-income ratio? It depends on the lender and several other factors, but most lenders look for a total DTI ratio (for installment loans) of less than 43%, sometimes even 36%. Many will also want your mortgage payment to take up no more than 28% of your income.
While your debt-to-income ratio isn't included in your credit score, many lenders consider income a factor in your ability to repay a loan. Some lenders have developed their own rating system, so their proprietary credit scores may use your debt-to-income ratio as a credit consideration. Having a high loan amount may not hurt your credit, but it could raise your debt-to-income ratio and lead to denied loan applications.
FAQs
Personal loans can boost your credit score by adding to your credit mix, improving your credit utilization ratio and your payment history. Applying for a personal loan can hurt your credit score temporarily and missing payments can lower it further.
How can loans affect your credit score? ›
Your credit score can dip a few points when you formally apply for a personal loan, but missed payments can cause a more significant drop. Getting a personal loan will also increase the amount of debt you owe, which is one of the factors that make up your credit score.
What factor has the biggest impact on a credit score in EverFi? ›
Your payment history and your amount of debt has the largest impact on your credit score.
What are the 5 biggest factors that affect your credit score investopedia? ›
The five biggest factors that affect your credit score are payment history, amounts owed, length of credit history, new credit, and types of credit. To improve your credit, it's important to understand how these factors impact your credit and what a credit score means when you apply for a loan.
Can a loan increase my credit score? ›
Though they're a form of debt, personal loans can also serve as a tool to build credit. This is because they can contribute to your payment history and credit mix, as well as lower your credit utilization ratio. Collectively, these three factors account for 75 percent of your credit score.
Can loans build your credit score? ›
Does getting a loan build credit? Yes, getting a personal loan can build credit, but only if the lender reports your payments to the credit bureaus. You'll borrow a fixed amount of money from a lender, which you'll then pay back in intervals over the course of the loan term, with interest.
What negatively affects your credit score? ›
Late or missed payments. Collection accounts. Account balances are too high. The balance you have on revolving accounts, such as credit cards, is too close to the credit limit.
What are the 5 C's of credit score? ›
The 5 C's of credit are character, capacity, capital, collateral and conditions. When you apply for a loan, mortgage or credit card, the lender will want to know you can pay back the money as agreed. Lenders will look at your creditworthiness, or how you've managed debt and whether you can take on more.
How do I see what is affecting my credit score? ›
You can get free weekly credit reports from each of the three nationwide credit agencies (Equifax®, Experian® and TransUnion®) at www.annualcreditreport.com. You can also create a myEquifax™ account to get multiple free Equifax credit reports each year.
What has the biggest effect on credit score? ›
Most important: Payment history
Your payment history is one of the most important credit scoring factors and can have the biggest impact on your scores. Having a long history of on-time payments is best for your credit scores, while missing a payment could hurt them.
Key Takeaways
- Credit risk is the potential for a lender to lose money when they provide funds to a borrower. ...
- Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
6 Reasons Why Using Cash Is Better Than Credit
- Accrued interest adds up on credit cards. ...
- Paying with cash vs. ...
- Cash makes it easier to budget and stick to it. ...
- You avoid additional fees. ...
- Not all vendors accept credit cards. ...
- Your personal information is protected.
Highlights: While older models of credit scores used to go as high as 900, you can no longer achieve a 900 credit score. The highest score you can receive today is 850. Anything above 800 is considered an excellent credit score.
What is true about payday loans? ›
How Payday Loans Work. Payday lenders take on a lot of risk because they don't check your ability to pay back the loan. Because of this, they normally charge very high interest rates for payday loans, and they may also charge high fees if you miss your repayments.
How to not go into debt? ›
How To Avoid Debt
- Set a monthly budget. Divide your monthly budget between three categories – necessities, wants, and pending debt.
- Pay with cash. ...
- Avoid “buy now, pay later deals” ...
- Track credit card payments. ...
- Have emergency savings. ...
- Stay up to date on loan payments. ...
- Limit amount of credit cards.
Hard credit checks temporarily lower your credit score by as much as 10 points. But if you have excellent credit, applying for a loan will most likely make your score drop by five points or less.
Do loans show up on your credit report? ›
Yes, personal loans show up on credit reports. Assuming you obtain a personal loan from a bank or personal loan company (as opposed to getting a loan from another individual), your account history will be reported to the three major credit bureaus—Experian, Equifax, and TransUnion.
How long do personal loans affect credit score? ›
The Initial Impact on Your Credit Report
However, the effect of a hard inquiry diminishes over time, and completely fades away within about two years. Additionally, opening a new credit account can lower your average credit age, which might also affect your score if you don't have a long credit history.
Is getting a personal loan a bad idea? ›
Personal loans tend to carry lower interest rates than credit cards, which can make them more affordable for borrowers. Before deciding to get a personal loan, you must consider potential downsides, such as high interest rates, steep fees and a hit to your credit score if used incorrectly.
