There are few things that can affect your life as much as your credit score. The three-digit number represents your history of repaying debt. It’s often the very first thing that’s reviewed whenever you apply for a mortgage, auto loan, or credit card. There are even some employers who will look into your credit report before hiring you.
The key to building up a high credit score is to take out debt and repay it over time. By doing so, you’ll be displaying to financial lenders that you’re capable of handling your finances.
The ensuing bump to your credit will increase the odds of loan approvals and lower their interest rates of them. Unless you’re really smart with saving your money, then you’ll probably need a loan in your life.
The problem with applying for a loan is that it can actually hurt your credit score. In order to properly review your loan application, a lender will have to conduct a “hard inquiry” into your credit. Unfortunately, there will be some consequences whenever this happens.
What Is a Hard Inquiry?
A hard inquiry is a term for whenever a loan lender, credit card company, or other entity requests a review of your credit report. The request is logged into your credit report and serves as a marker for when you applied for new credit.
Having a lot of hard inquiries on your credit report can make you appear desperate for financial assistance. It might make a lender wary of accepting your loan application.
It’s important to note that not all requests will appear on your credit report. There is such a thing as a “soft inquiry” that isn’t recorded. These inquiries are less detailed than a hard inquiry and are what happens when you personally check your own credit.
In some cases, a loan lender or credit card issuer will use a soft inquiry when they pre-approve you for an offer.
It’s the legal responsibility of a financial institution to inform you that they’ll need to perform a hard inquiry instead of a soft one. You have to explicitly grant them permission to pull your credit report. The reason for this authorization is that hard inquiries unfortunately come with a few negative effects.
How Much Damage Does a Hard Inquiry Do?
The bad news is hard inquiries will deduct several points from your credit score. The effects can be minimal (roughly one to five points) if you have a high score and long history. However, this change can be much more significant if you have a short credit history, few open accounts, or are trying to build credit.
The good news is that hard inquiries, or “new credit”, only make up about 10% of your overall credit score. By keeping the other 90% in an optimal range, the damage for hard inquiries shouldn’t be too bad. Besides, you can’t take out a loan without a hard inquiry anyway. It’s best to think of it as the initial cost of eventually building a strong credit report.
The key thing to remember is to limit your hard inquiries as much as you can. One or two inquiries aren’t harmful by themselves. But studies have shown that people with six or more recent inquiries are eight times as likely to file for bankruptcy as opposed to those with none. The credit score formula takes this into account and will lower your score dramatically.
When Does A Hard Inquiry Fall Off of Your Credit Report?
Fortunately, credit reports are not a permanent record of your financial history. The negative information that’s recorded on your credit report will typically only stick around for seven years. There are a few extenuating circumstances, but delinquencies, defaults, foreclosures, lawsuits, and most bankruptcies are all removed after seven years.
Hard inquiries have a significantly shorter life span on your credit report. A hard inquiry will only show up on your credit report for two years and usually doesn’t do any damage after the first year. Maintaining the other factors of your credit score will usually repair the damage of a hard inquiry within the first 12 months.
What Factors Affect Your Credit Score?
- Payment history (35%)
- Amount owed (30%)
- Credit history (15%)
- Credit mix (10%)
As mentioned earlier, hard inquiries are categorized as “new credit” on your credit report. The new credit category only makes up 10% of your overall score. The additional 90% is divided into four other categories, including:
Payment History (35%)
Payment history is the single largest contributing factor to your credit score. Having a single missed payment can be enough to significantly impact your credit score. Not just that, but delinquencies can stick around on your credit report for up to seven years. It can’t be overstated how important it is that you make your monthly payments on time.
A history of being late with payments or defaulting on loans is the quickest way to scare off potential lenders. Their primary concerns are to be repaid consistently and on time. Unless they believe that you’re capable of repaying the loan, they’ll have no issue denying your application. Your loan is basically a long-term investment for them and they really don’t like taking risks.
Amount Owed (30%)
The amount of debt that you owe and how you use your credit is almost as important as payment history. The key to understanding this factor is figuring out your credit utilization ratio. In order to calculate this ratio, you’ll need to divide your total account balances by the sum of your credit limits. In other words, how much you currently owe is divided by your maximum open credit limits.
For example, let’s say that you have three credit cards with limits of $500, $3,500, and $8,000. That would give you a total of $12,000 in potential credit. If you owed $125, $1,550, and $3,325 on these accounts, then you would have a total debt of $5,000. Dividing your total debt ($5,000) by your total credit limit ($12,000) would give you a credit utilization ratio of 41.6%.
Ideally, you should try to keep this ratio under 30%. Anything higher will indicate that you’re struggling to keep your debt down and might worry potential lenders. That doesn’t mean that you should open a credit card and never use it. Instead, only use them to make purchases that you can easily afford. Using the card often and paying off the balance is really beneficial to your credit score.
Credit History (15%)
Credit history is one of the easier categories to understand. The way it works is that the average age of all your credit accounts is factored in with the ages of your oldest and youngest accounts.
It’s fairly simple: the length of a credit history that you have, the better your score will be. It’s the reason why experts recommend that you never close your first credit card.
Unfortunately, there isn’t much that you can really do to quickly improve your credit history score. Opening up a new line of credit will lower your average age and possibly lower your score. However, leaving this line open for a long period of time will eventually be beneficial to your score.
It might be a good idea to open up a new line of credit every couple of years. As long as you use it responsibly, you’ll be able to build up a stronger credit history. The hard inquiries can potentially hurt your score in the short term, but you’ll have a higher credit limit immediately and build your credit in the long term.
Credit Mix (10%)
The last influencing factor is your overall mix of credit. Having a diverse portfolio of credit accounts will illustrate to potential lenders that you’re very responsible for repaying debt. It’s not uncommon for people with excellent credit scores to have a mortgage, car loan, credit cards, and student loans. Being able to manage all of these different types of debt will help improve your credit score.
Now that doesn’t mean that it’s a good idea to run out and start taking on new types of debt. The credit mix is only 10% of your score, so it’s much more important to make payments on time and keep your credit utilization low. You should think of the credit mix as more of a potential bonus as opposed to specifically planning to improve it.
The Takeaway
Hard inquiries are a necessary part of the loan application process. You’ll need to be smart when applying for anything that requires a hard inquiry. They’ll knock off a few points on your credit score and stick around on your credit report for up to two years.
The good news is that hard inquiries only represent 10% of your overall score. Making your monthly payments on time and keeping your credit utilization ratio low should allow you to quickly erase the damage of a hard inquiry.
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