Chris Bridges, Founder and CEO, VITAL Card Inc.
Student loans, car loans, and home equity — the list of different types of credit lines and loans is extensive. With more loan offers available today than ever before, you might be wondering, “How much does a loan affect your credit score?”
After all, it can be a challenge to understand how each kind of loan works and the impact it could have on your credit. But whether you’re aiming to buy a car or finance your education, deciding whether or not to take out a loan will often be part of the equation.
Let’s delve into what you need to know about loans and how they may influence your credit score.
What Is a Credit Score and How Is It Calculated?
Meant to represent an individual’s creditworthiness, a credit score is a numerical figure determined by the three primary credit bureaus — Equifax, TransUnion, and Experian — which often ranges from 300 to 850.
Think of a credit score as a grade or evaluation lenders and banks use to decide if they should trust you and give you a loan. Excellent credit scores are usually 800 and above, while scores of 579 and under are generally considered poor credit.
The most common credit scoring models are FICO and VantageScore, and each weighs different factors to calculate your credit score. These factors include considerations such as the length of your credit history and your outstanding debts and credit mix.
A good mix of credit generally includes both installment loans (e.g., auto or mortgage loans) and revolving credit accounts (e.g., credit cards). For FICO Scores, payment history is one of the most important factors in determining your score.
Another factor included in your credit score is your credit utilization ratio. This refers to the amount of debt you have compared to your available credit limit.
What Are the Different Types of Loans?
When it comes to understanding the wide variety of loans, the first step is knowing the differences between secured and unsecured loans.
Secured loans, like mortgages and car loans, tend to require collateral like a house or vehicle to back the loan amount. The collateral guarantees that the lender will receive some form of compensation in the event of a default on the loan.
On the other hand, an unsecured loan, such as a credit card or student loan, typically does not require collateral.
In addition, lenders will still need to assess your creditworthiness and ability to repay the loan before approving the amount. And because there is no collateral involved, interest rates on unsecured loans are often higher than on secured loans.
Personal loans are usually unsecured, meaning they don’t require collateral. This opens up a financial avenue for people who do not have equity in their homes or other assets to use as collateral.
Borrowers can use personal loans for a variety of purposes, including paying off medical bills, high-interest credit cards, and unexpected expenses. The amount you qualify for and the interest rate you receive will depend on your credit history and ability to repay the debt.
A student loan is a form of financial aid that borrowers must repay, often with interest. Student loans can be issued by private lenders, the federal government, or other sources, such as a school or state government.
Fortunately, student loans can positively impact your credit score when managed responsibly. Making timely payments on student loan debt can often help build your credit, while failing to make payments may lead to a lower score.
Many homebuyers take out a mortgage to pay for their home. Defaulting on this secured loan can result in the lender foreclosing on the property and selling it to recoup the loss.
On average, qualified borrowers for a mortgage tend to have a credit score between 500 and 700. In addition, mortgages are typically paid back over a period of between 15 and 30 years, and the interest rates are typically determined by the market conditions at the time of borrowing.
Also referred to as a car loan, these loans are secured by the vehicle itself and are considered a type of installment debt. This is because they usually involve making regular monthly payments over an extended period — often around six years.
Auto loans can be used to finance both new and used vehicles. During their assessment process, lenders will review the value of the vehicle you are looking to purchase and your ability to make the monthly payments.
Debt Consolidation Loans
If you’re struggling to make ends meet each month and facing difficulties with multiple creditors, a debt consolidation loan could be a good option.
As its name implies, this type of loan consolidates multiple types of debt, including credit card debt, medical bills, student loans, and more, under one lender. When you consolidate your debt, you’ll take out one loan to pay off all of your other debts.
Many debt consolidation loans come with lower interest rates than the interest rates on your individual debts. And since you’ll only have one monthly payment to make instead of several, it’s possible you might save money on interest over time.
How Much Does a Loan Affect Your Credit Score?
Those concerned with their personal finances may wonder, “How much does a loan affect your credit score?” This is a fair question to ask since your credit score can determine which loans you qualify for, as well as your repayment terms and interest rates.
When you apply for a new credit card or loan, the lender will run a credit check to ensure you are a responsible borrower who will be able to make on-time payments. This results in a hard inquiry on your credit report, which may temporarily decrease your credit score.
The credit inquiry lets the lender review your financial situation, including how many lines of credit you currently have open and any derogatory marks you may have due to late payments, defaults, or bankruptcies.
Using this information, lenders can assess your riskiness as a borrower to decide whether or not to approve your loan or credit card. While creditors prefer borrowers with a high credit score, those with lower credit scores can still be approved for a loan, though they will often have a higher interest rate.
Generally, loans can help you can build credit by expanding your credit mix and history and showing lenders that you’re able to responsibly manage debt. However, not every loan will be advisable for every person to take. You may want to consult with a financial advisor before opening up a new loan, especially if you’re not sure about your current financial situation.
What Happens If You Miss Payments on a Loan?
When you miss payments or default on a loan, not only can the lender charge a late fee, but you may also see an adverse effect on your credit score.
However, there’s no universal way to calculate how much your credit score might change. This is because each credit bureau uses its own unique algorithm to calculate your credit score, weighing factors such as credit mix and payment history differently.
After a short period of time — typically 30 days from when your bill was due — your lender may report the late payment to the credit bureaus, leading to a derogatory mark that can damage your credit score.
The negative mark will typically stay on your credit report for a maximum of seven years. In addition, the amount of debt you have relative to your income, also called your debt-to-income ratio, could also affect your credit score.
For example, if you have a lot of debt compared to your income, this could indicate that you may be struggling to make your payments, which can be a red flag for lenders and can potentially affect your credit score.
How Long Does a Loan Remain on Your Credit Report?
When a borrower submits a loan application, their credit report will receive a hard inquiry. This mark generally stays on your credit report for two years.
Most loans remain on a borrower’s credit report during the entire repayment period and for up to seven years after the amounts are paid off. The exception is unpaid student loans, which can continue to appear on your credit report indefinitely until the balance reaches zero.
The Bottom Line
When you have a large expense coming up, it’s only natural to consider taking out a loan. For many, large purchases (such as houses or cars) can only be made with the help of loans.
It’s only natural to wonder how a loan may affect your credit score. Essentially, taking out a loan may support your credit health by strengthening your credit mix. However, it can also damage your credit score if you fail to make timely payments.
Ultimately, taking on additional debt will affect everyone differently, depending on the type of debt they’re taking out and their unique financial situation.
If you’re looking for ways to share and spend responsibly, check out VITAL Card. This card offers generous cash rewards designed to encourage responsible spending, and cardholders have can monitor their VITAL signs to build strong financial habits.
Learn more about the VITAL Card today to see if it’s right for you.
VITAL Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.