Taking out a loan can send out ripples that affect not only your personal finances but also your credit score. Whether that’s a good or bad thing depends on your ability to service the loan, plus other factors. Here are some borrowing dos and don’ts related to your credit score to help you stay on track with your financial goals.
How does taking out a loan affect your credit?
Taking out a loan affects your credit score in various ways. Generally, the impact is initially negative because the lender will do a hard credit pull when you apply. That means the lender combs through your credit report to figure out the risk you pose as a borrower.
This enquiry gets recorded on your credit report, and each time there’s an enquiry, your score drops by a few points.
However, it can quickly bounce back once you start paying off your debt as agreed. In Australia, credit bureaus like Experian and Equifax mainly use the following factors in their credit scoring models:
- Your payment performance. Your credit score will be lower if your payment history includes missed payments, defaults, court judgements, insolvency issues, or bankruptcies. These financial mishaps raise questions about your ability to pay back a new loan, and lenders may label you as a high-risk borrower.
- Credit utilisation ratio. This refers to how much credit you currently owe vs. your credit limit. Having more available credit helps to boost your credit score.
- The types of loans you have. Managing multiple credit accounts responsibly is one characteristic of a good borrower. Besides personal loans, your accounts may also include credit accounts, car loans, home loans, and student loans. This is called credit mix, and the more diverse it is, the better your credit score health.
- Your credit history length. Credit score calculations also factor in the number of credit accounts you have and how long they have been active. This helps lenders determine if you have a good track record.
Keep in mind you may have different credit scores depending on which credit scoring model is used.
Things that won’t affect your credit score when borrowing
Your personal finances are defined by various factors and behaviours, but not all will affect your credit score. Take the following factors, for instance:
- Debt to income ratio. Your DTI is a measure of how much you owe per month vs. your monthly earnings. Since information about your income is not included in your credit report, your DTI won’t affect your credit score. However, lenders typically consider your DTI when deciding whether to approve your application.
- Soft credit pulls. A soft enquiry or soft credit check happens when you view your credit file or permit someone else to do so. It doesn’t affect your credit score because it’s not tied to any specific loan application. You can use this opportunity to check your credit file and fix any errors that may be causing your credit score to dip.
- A denied application. The lender may decline your application for reasons such as a poor credit history and inability to service the loan. While this doesn’t affect your credit score in and of itself, keep in mind that the application comes with a hard enquiry, which lowers your rating slightly. However, this also applies even if the loan is successful.
- Talking to a financial counsellor. Should you face any financial difficulties related to your debts, don’t hesitate to seek advice from a qualified credit counsellor. For starters, the National Debt Helpline offers free financial counselling that won’t impact your credit score in any way.
How to boost your credit score when taking out a loan
Here’s how you can use a loan to push your rating up:
Apply for a debt consolidation loan
Debt consolidation loans are handy financial products that help you get rid of multiple credit accounts. In a nutshell, consolidating your debts makes your repayments more manageable, and this can improve your payment history as long as you avoid taking on extra debt you can’t afford.
Expand your credit mix
If you already have other credit accounts, taking out a new type of loan helps boost your credit score. For instance, if you already have several credit cards, a mortgage, and an auto loan, adding a personal loan diversifies your credit mix and shows you can responsibly handle various kinds of credit.
Make repayments on time
After shopping and applying for the right loan, you must honour the due dates of your repayments. That’s because having a positive payment history is one of the top ways to build your credit score. To make life easier, you can opt for automatic repayments and choose a repayment frequency that matches your cash flow, whether that’s weekly, fortnightly, or monthly.
How to avoid damaging your credit score when taking out a loan
Don’t make multiple credit applications
As mentioned before, your loan applications generate hard enquiries, which are recorded on your credit report. While a single application won’t affect your credit score by much, several applications in a short time can significantly lower your credit score.
Additionally, enquiries can stay on your credit report for years. Too many enquiries increase the risk you pose to the lender, which lowers your chances of approval or getting a good deal.
Only borrow what you can afford
It’s true that you have to borrow and diversify your credit score to build a good rating. However, it’s best not to borrow solely for this reason. Instead, first consider if borrowing is necessary and if it is, be sure to borrow an amount that matches your budget. Borrowing more than you can afford may end up denting your credit score if you default or miss payments.
Top tip: You can use BestFind’s personal loan calculator or car loan calculator to find affordable repayment estimates before committing to a loan.
Don’t overuse your revolving credit
Revolving credit includes credit cards and personal lines of credit. It’s best to keep the balances on these accounts below 25% or 30% of your limit to keep your credit utilization rate low. If you have used up most of your available credit, it means your required monthly repayments are higher, and your credit score will likely drop. In short, a high revolving total indicates risky borrowing behaviour.
Final word
Will taking out a loan upgrade or downgrade your credit score? To summarize, your credit score represents the information in your credit report. Things like too many hard enquiries and missed payments will negatively affect your credit score.
On the other hand, sticking to your repayment schedule and clearing some of your debt can boost your score. But with so many factors in the mix, how much a personal loan affects your credit score all boils down to your circumstances and borrowing behaviour.
The good news is, you can use the information in this article to make sure that taking out a personal loan only affects your credit score positively in the long run.