Loans—and how you manage—them are the most important factor in your credit. But credit is complicated, and depending on the state of your credit, you might wonder if loans help or hurt your credit scores.
They help you build credit if you successfully make payments.
They hurt your credit if you pay late or default on loans.
They reduce your ability to borrow (which might not directly affect your credit scores).
They cause slight damage to your credit at first, but they can easily recover if you make payments on time.
Your credit is all about your history as a borrower. If you’ve borrowed and repaid loans successfully in the past, lenders assume that you’ll do the same in the future. The more you’ve done this (and the longer you’ve done it), the better.
Taking out a new loan gives you the opportunity to repay successfully and build up your credit. If you have bad credit—or you have never yet established credit—it will improve over time with each monthly on-time payment.
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. If all of your loans are credit cards, that might be fine, but your mix is better if you also have an auto loan or a home loan.
Don’t borrow just for the sake of trying to improve your credit. Just borrow wisely, if and when you need to, and use the right loan for the job.
Of course, those loans don’t do you any good if you pay late or stop making payments: your credit scores will quickly drop, and you’ll have a harder time getting new loans.
New loans affect more than just your credit scores; they also reduce your ability to borrow.
Your credit reports show every loan you’re currently using, as well as the required monthly payments. If you apply for a new loan, lenders will look at your existing monthly obligations and decide whether or not they think you can afford an additional payment. To do so, they calculate a debt to income ratio, which tells them how much of your monthly income gets eaten up by your monthly payments. The less, the better.
You don’t even have to borrow to see your borrowing ability reduced. If you cosign a loan for somebody (helping them get approved based on your strong credit and income), that loan shows up on your credit report. You’re 100 percent responsible for repaying the loan if the primary borrower does not repay, so lenders generally count that as a monthly expense (even though you’re not making any payments).
New loans generally create a slight dip in your credit scores. If you have strong credit, that dip is probably short-lived and insignificant. But if you have poor credit (or you’re building credit for the first time), that dip could cause problems, so avoid racking up debt before you apply for an "important" loan like a home loan.
Every time you apply for a new loan, lenders check your credit. When they do so, an “inquiry” is created, showing that somebody pulled your credit. Inquiries can be a sign that you’re in financial trouble and you need money, so they pull your score down slightly. One or two inquiries aren’t a big deal, but numerous inquiries can damage your scores.
If you’re going to shop among lenders—which is wise, and it’s the only way to get the best deal —do all of your shopping within a relatively short time frame. For example, if you’re buying a home and comparing mortgage lenders, complete all of your applications within 30 days or less (the credit scoring models give you a pretty generous window). For auto loans, try to keep everything within two weeks.