How Does a Loan Affect Your Credit Score?
May 8, 2013
You just completed the paperwork on a new loan. Because of your excellent credit score, you got an outstanding rate on the loan. But 30 days later you pull your credit report and find out that your credit score dropped by 40 points. Everything else on your report is consistent with what has been there before, the only difference is the new loan.
Did that cause your credit score to drop? And if so, why?
Unproven Payment History
If you are not fully familiar with the credit universe it can be a shock to find that a new loan will cause your credit score to drop. That is actually more common than not.
When you take a new loan, there is no payment history on the loan. While we might assume that a new loan should be neutral in terms of credit score â€“ after all, you haven’t missed any payments yet â€“ credit repositories take the position that a new loan represents a new risk.
Even though both you and the lender are extremely comfortable with your ability to pay the loan in a timely fashion, credit scores are a measure of risk â€“ and new loans add plenty of it.
It actually makes sense. Letâ€™s say that your total monthly debt payments are $1,000. Thatâ€™s everything â€“ car payment, student loan payment and credit cards. But you decide to buy a second car with the payment of $400 per month.Â Your monthly obligations will rise by 40%, and there is no payment history at that level of debt to indicate that you will be able to do that successfully.
The credit scoring models are assuming the worst here, but when you look at it as described above, the additional debt is a negative and that has to be reflected in your score.
Number of Loans Outstanding
Credit scores also reflect the number of loans you have outstanding. If you already had six loans with outstanding balances, and you add one more to the mix, you now have seven loans with outstanding balances.
The credit scoring models consider the additional debt to be an additional risk, and therefore it is a ding against your credit score.
Credit utilization measures the amount of credit you have outstanding to the amount of credit limits you have in available. For example, if you have a $10,000 credit line, and $6,000 of it is outstanding, your credit utilization is said to be 60% ($6,000 divided by $10,000).
The lower your credit utilization is, the more positive it is for your credit score. And obviously, the higher it is the more negatively it impacts your score. When your utilization gets up around 80% or higher, the negative impact is more severe.
Credit utilization is more pronounced among revolving lines of credit, which is mostly credit cards. But it is also likely that an installment loan will also have a negative impact while the outstanding balance is at or near the original loan amount.
Different Loans, Different Credit Score Impacts
The type of loan that you have is also a factor. For example, a new mortgage loan will generally not have as much of a negative impact as say, a new auto loan. There is actually a hierarchy within the credit scoring models as to loan type, and mortgages are at the top (seen as the least risky debt type).
Next in line are auto loans, followed by credit cards, and at the bottom of the heap are consumer installment loans, such as loans for furniture and such.
That being the case, taking a new loan to buy a computer, will have a greater negative effect on your credit score than taking a new mortgage.
Good News: â€œSeasoned Loansâ€ have a Positive Effect
So far we been discussing the negative impacts of a new loan on your credit score. But there is light at the end of the tunnel.
The longer your loan has been outstanding, and the longer you have been making timely payments, the greater the positive impact will be. Yes, your credit score will drop upon taking a new loan, but as time passes the effect of the loan will go from negative to positive.
For example, if you take an installment loan for 60 months and you are halfway through, the payment experience on that loan will be a positive factor for your credit score. Lenders refer to mature loans as â€œseasoned loansâ€ â€“ theyâ€™ve been around for a while, thereâ€™s a readily identifiable pay history, and the payments have been made on time.
This is why people who have long credit histories usually have better credit scores than those who are fairly new to the credit world. A pattern of paid and almost paid loans has a major positive impact on your credit score.
So if you are worried about the new loan dropping your credit score, just sit back relax and make your payments on time â€“ it will all start working in your favor soon enough.
Have you ever experienced a credit score drop after taking a new loan? Leave a comment and tell us about it!
All posts by Kevin Mercadante