How Loans Shape Your Credit Score

Many of us have heard the famous line from Shakespeare’s play Hamlet, "Neither a borrower nor a lender be."  The character in the play who shares this sentiment with his son suggests that borrowing money can lead to debt and financial problems. While this may be a fact, for the average person, never needing to take a loan is the stuff of fiction. Most people will probably need to borrow money at some point to purchase a home, car or finance a college education.

However, if managed responsibly, a loan doesn’t have to break the bank. Good stewardship involves understanding your credit score, but most people don’t think about the impact of a loan on their credit score. 

Think of your credit score as your financial report card. Most people know credit scores are important for acquiring credit cards or securing loans and mortgages with good interest rates. They are a measurement that give lenders an idea of the risk involved in lending money to someone. The scores range from 300 to 850 and are obtained from credit reports based on credit history with the three main credit bureaus: Equifax, Experian and TransUnion.

Whether you're considering a personal loan, a mortgage, or an auto loan, knowing how loans can affect your financial health is essential. Here are some details about how loans can impact your credit score for better or worse. Advantages of taking loans include:

• Payment History: Timely loan payments positively affect your credit score since payment history is a significant factor in credit scoring models. Consistently making on-time payments demonstrates reliability to lenders.
• Good Debt:  Good debt is typically a loan that could be considered an investment in yourself that will grow in value or generate long-term income if you make your payments on time. Examples include a home mortgage, a student loan or a business loan.
• Achieving Your Goals: Loans can help you reach your objectives, such as owning a home, making home renovations, attaining a college degree or opening a small business.
• Credit Mix: Having more than one type of credit, such as a low-interest credit card and a mortgage, may improve your credit score a little if you can afford them and make your payments on time. Lenders like to see that you can manage different types of credit responsibly. This is a less significant factor in your credit score than your payment history or how long you have had credit.¹

Some of the disadvantages of taking loans include:

• Hard Inquiries: Applying for a loan results in a hard inquiry on your credit report, which can temporarily lower your credit score. Multiple hard inquiries in a short period can have a more significant negative impact. According to Experian.com, "a hard inquiry is a request by a lender to view your credit report as part of an application for credit."
• New Credit: Opening a new loan account can decrease the average age of your credit accounts, potentially lowering your credit score.³ The average age of your credit accounts is the average period of time your credit practices have been monitored by credit agencies. Lenders prefer to see a longer credit history.
• Missed Payments: Missed or late loan payments hurt your credit score. More serious consequences include foreclosure for missed mortgage payments and legal action for student loan delinquency. It's crucial to make all loan payments on time to maintain a good credit score and avoid financial troubles.

• Bad Debt: Bad debt is incurred when you purchase depreciating assets or use loans to consume items that do not generate future income. Examples include:
  • Credit Card Debt: High-interest credit card debt used for everyday expenses or non-essential items can quickly become unmanageable. Keeping your credit card utilization ratio below 30 percent is recommended. Your credit utilization ratio is the amount of credit you use compared to your total credit limit.
  • Personal Loans for Non-Essential Items: Borrowing for vacations, luxury items, or other non-essential expenses can be considered bad debt. Non-essential items don’t generate future income.²
• Interest rates: You will have to pay interest on any debt you incur on top of the original loan amount.

So, what's the takeaway? Loans can have both positive and negative effects on your credit score. The key is to manage them responsibly. Taking out a loan just to increase your credit score or build a credit history is not recommended. It’s best to only take out a loan if you really need it. When you do, it’s important to:

• make your payments on time.
• avoid taking on more debt than you can handle.
• keep credit card balances low.
• limit hard inquiries and monitor your credit report.

By doing so, you'll maintain a healthy credit score and build a strong financial foundation for the future.

Remember, your credit score reflects your financial habits. Treat it with care, and it will reward you with better loan terms and financial opportunities.

Sources:

1. "Credit Mix: How Credit Types Affect Your Score."
2. "How Does a Personal Loan Affect Your Credit Score?"
3. How loans can affect your credit score - CBS News