A loan is a sum of money given to a borrower by a lender, with a commitment or a contract to repay in a certain number of payments in installments after fixed intervals of time. The term “credit” refers to a belief or trust that any borrower will be able to repay or return the money borrowed. Bad credit scores would indicate that you are unlikely to pay your dues off on time, which would make you unfavorable to most creditors. Your credit score is, hence, a record of the exact credit history you have at that point in time.
The loans you have taken and the manner in which you have handled them form the most important factor that affects your credit score. Credit is rather complicated, and it is important to factor in the effect of any debt you take on before actually signing up. Your credit score is altered by new and existing loans in several ways. If you have made payments successfully in the past, they help you build credit, but have severely detrimental effects if you have defaulted in the past. Loans will reduce your borrowing capacity, but this may not affect your credit score directly. They cause minimal damage to credit initially but can be recovered rather easily provided you keep up with all the payments.
Just Applying for Loans Impacts Credit
Even applying for a loan lowers your credit score by a few points. This is because one-tenth of the credit score depends on how many credit-based applications you have made. Hence, every time you apply for credit, there is an inquiry placed on your credit report which indicates that it has been reviewed by a lender. Too many inquiries, especially if made in a very short time window means that you are desperate for loans and are taking on much more debt than you can handle. For particular types of loans like auto or mortgage loans, however, there is a “grace period” given during which you can take a number of loan inquiries without any effect on the credit score. All the inquiries are treated as a single application, and the window is usually anywhere between 14 to 45 days.
Credit Score Raised by Timely Payments
It is vital that you make all your monthly payments on time, once your loan has been approved. 35% of your credit score is payment history, which outweighs all other factors. You become a more attractive borrower if you can keep up with all your payments on your personal loans, but the reverse could have quite a disastrous effect on the credit score, and very serious cases of defaulting could end in repossession and eventual foreclosure.
Balance of Loans Is Also a Factor
The balance of your loan is a fairly large influence on the credit score, as you gain more points if you keep paying your dues. The credit score is great as long as the gap between the loan amount and current balance is wide enough.
The Debt-to-Income Ratio
The credit score sold by FICO and other credit bureaus does not include the ratio of your loan to your income but is definitely considered by several lenders who want to estimate your ability to repay the debt. This ratio compares all your credit cards and loans to your total income, and a high score could be viewed as risky and lead to denial of loans.
The credit score is literally the history of a person as a borrower. The more you have repaid all the loans you have borrowed in the past, the better it is for you. Both the frequency of loans and the time period over which they were taken and returned successfully are taken into consideration. Hence, taking new loans provides you the opportunity to build up your credit by repaying successfully. Bad credit or credit which simply hasn’t been established yet can both be fixed with regular on-time monthly payments.
1/10th of the credit score provided by FICO is also based on something called a credit mix, which is the variety of accounts or the types of loans on your credit report. Getting different types of loans also helps your credit. 10% of your FICO credit score is based on your “credit mix,” which looks at the variety of accounts on your credit report. Hence, it makes sense to have had different types of loans in the past. You don’t need to borrow for the sake of improving credit because that makes no sense. It is, however, prudent for you to borrow wisely, pick the right credit option and repay on time, no matter what.
Author Bio: Katie Dickson is a finance-related blogger and a consultant at a private finance firm, and has helped a number of clients consider, analyze and understand personal loans, debt management, and bankruptcy so they can deal with their financial situations better.