If you’re looking for a quick answer: Yes, applying for a personal loan will involve a hard credit search which will have a short-term impact on your credit score. If you decide to get a personal loan this will further affect your file. It will increase your debt-to-income ratio which could be a factor in a lender's affordability checks. However, a loan may also improve your credit mix and help you to build up your credit history. So, if you pay off your loan on time each month and prove you can handle debt responsibly, you may find that taking out a loan can actually have a positive effects on your credit score.
In this guide, we explain why applying for a loan could affect your credit score and how best to monitor and manage this...
- How does a credit score work?
- Understanding credit reports and credit reference agencies
- Hard searches vs soft searches
- The impact of multiple hard searches on your credit score
- Immediate effects of loan applications on your credit score
- Long-term effects of loan applications on your credit score
- Monitoring and managing your credit score
- Minimising the impact on your credit score when applying for a loan
- Final thoughts
How does a credit score work?
A credit score is essentially used to predict how likely you are to pay back the money you’ve borrowed. This helps lenders determine which applications to accept, and what rate to offer.
While credit scores aren’t universal, they can be used to give you a general idea of how likely you are to be accepted for credit. Different organisations have their own scoring systems to help them determine whether an individual is a suitable fit for a certain product, though – so never take a credit score you see online as gospel.
That said, most organisations will use similar factors to work out your credit score. So it’s safe to assume that if something impacts your credit report (i.e. failing to make your mortgage payments) this will be reflected on your overall credit score too.
Information from your credit report is usually used to develop your score. Factors such as how you’ve managed debt in the past, your recent financial and personal circumstances, and levels of debt are all likely to have an impact on your credit score.
As your creditworthiness is a key factor in any lender’s decision-making process, you should be mindful of any action that could impact your credit history – including applying for credit or taking on any additional debt. This could affect your ability to borrow both in the short and long term.
For more information on credit scores and how they work, read our credit score guide.
Understanding credit reports and credit reference agencies
A credit report is a record of how you typically manage your finances, giving a detailed overview of your credit history. This helps finance providers to determine what kind of customer you might be (i.e. whether you’re likely to pay back the money you’ve borrowed on time).
Credit reports are created by credit reference agencies (CRAs) by compiling a mix of public information and credit information held about you by lenders. The main three CRAs to be aware of are Experian, Equifax and TransUnion.
Finance providers and lenders are then able to use the information provided by CRAs to conduct affordability and credit risk checks, helping them make a decision on your credit application.
The information found on your credit report is also used by lenders and CRAs to calculate your credit score. Therefore, when you apply for a personal loan or take out credit, this will be recorded on your credit report and thus may impact your credit score in the future.
Our article covers everything you need to know about credit reports, should you wish to find out further information.
Hard searches vs soft searches
When you apply for a finance product – which can be anything from a mobile phone contract to a loan – a soft or hard credit search will be conducted. This helps the finance provider or lender decide whether they’re able to offer you the product.
A more basic soft search is not recorded on your credit report, and therefore won’t affect your credit score. Think of it like a ‘mini’ search that gives the lender an overview of your financial history. Soft search is often used to give customers an idea of how likely they are to be accepted for a finance product before going ahead with a hard credit search.
Soft checks mostly happen when you’re checking your eligibility for credit, if you’re searching your own credit report, or as part of identity checks. Hard searches are typically used if you have applied for a financial product such as a credit card, loan or mortgage.
A hard search allows lenders to dive deeper into your credit history. They’ll be able to see information about your financial history and how you’ve handled debt in the past. While usually not a problem, hard credit searches will be recorded on your credit file and will remain there for up to 12 months.
Remember – you’ll always be subject to a hard credit check once you submit a credit application, regardless of whether a soft search has previously been conducted.
The impact of multiple hard searches on your credit score
As every hard credit check is recorded on your credit file, lenders will be able to see how many searches have been conducted. Though the outcome of any applications won’t be visible, too many hard credit checks in quick succession could be a red flag to the lender. It could suggest financial instability, or urgent need for credit.
It’s understandable to want to shop around for the best interest rate when looking for a finance product such as a loan, credit card or mortgage. However, it is not recommended to submit several applications at once. Instead, do your research on different lenders thoroughly to make sure you’re only applying for the most suitable products.
So what should you do if an application is declined? Instead of approaching multiple different lenders straightaway, it might be worth pausing to review your credit file. Ensure the information stated is correct and, if so, follow our top tips to help improve your credit score to put you in the best possible position when you do make another application.
Immediate effects of loan applications on your credit score
A hard credit search will be conducted when you apply for a personal loan. And, as we’ve already discussed, every hard credit search is recorded on your credit file. Therefore, any full personal loan application will have an immediate impact on your credit score.
Though hard searches will stay on your credit file for at least a year, it’s likely any effect on your credit score will be much more temporary. That said, multiple hard searches in quick succession is likely to have a greater impact – potentially affecting your credit score until the hard enquiry is cleared from your credit record.
Long-term effects of loan applications on your credit score
Simply applying for a personal loan is unlikely to have a long-term effect on your credit history. However, should your loan application be accepted, there are several ways this could impact your credit score - though not necessarily in a bad way. Provided you manage your finances effectively, there’s no reason why taking out a loan should harm your credit score in the long term. In fact, you may find it has a positive impact instead.
A new loan could impact your credit mix
Taking out a personal loan adds to your credit mix, which could contribute positively to your credit report.
Lenders like to see you can responsibly handle lots of different types of credit, including:
- Instalment credit: allows you to borrow a pre-agreed sum of money and pay it back in equal instalments over a set period
- Revolving credit: you’re able to borrow up to a maximum amount, but can vary how much you pay off that balance each month (though you will be required to pay a minimum amount)
Taking out a loan could add to your credit mix which, provided you keep up to your repayments, may reflect positively on your credit history.
A loan could also help you to build your credit history if you have a thin credit file, which basically means you have limited experience of managing debt. It will give you an opportunity to prove that you’re able to make your monthly repayments on time, showing future lenders you’re a good customer.
Do note, though, to never take out a loan with the sole purpose of adding to your credit mix or building up your credit history. You should only use credit if you really need to, and if you’re in a financial position to make your repayments on time each month.
Additional debt increases your debt-to-income ratio
Lenders want to make sure you can afford to take on additional debt comfortably, so they’ll assess how much of your income is being used to pay off debt. Of course, taking out a loan will increase your debt-to-income ratio and this could play a part in a lender's decision making process.
Repaying your debt should ideally equal no more than 40% of your monthly income so think carefully before taking on any more debt if it will end up significantly eating into your income.
It may be more difficult to borrow again until some of your existing debt has been paid off if the lender feels you may not be able to afford to repay additional debt.
Before committing to taking out a personal loan and increasing your debt-to-income ratio, use a loan calculator to work out how much your monthly repayments will be. You can then make sure you’ll be able to comfortably make the monthly repayments.
How you handle your repayments could impact your payment history
This one’s obvious, but how you handle your loan repayments will have a big impact. In fact, payment history is one of the most important factors when calculating a credit score.
If you make your repayments on time and in full each month until the loan is settled, this will likely have a positive impact on your credit history over time. This is because you can prove you have a strong payment history.
However, late or missed payments will be recorded on your credit file and will stay there for up to six years. This will have a detrimental effect on your credit score. This could seriously affect your ability to borrow in the future.
If, for whatever reason, you do find your repayments becoming unmanageable it’s important to contact your lender as soon as possible to try and find a suitable resolution.
Paying your loan off in full could improve your credit score
Paying off a loan not only reduces your debt-to-income ratio, but it also proves you have been able to abide by the terms set by your lender and pay back the money you’ve borrowed. This will have a positive impact on your credit score around 30 days after you’ve paid off your debt once the lender has reported all relevant information to the CRAs.
The best way to mitigate long-term adverse effects on your credit score is to ensure you’re managing your debt responsibly. Only borrow the money you need and can comfortably afford to pay back each month, giving you the best possible chance of demonstrating good debt management.
Monitoring and managing your credit score
Keep an eye on how your loan applications or current credit commitments are impacting your credit history.
While checking your credit score online can give you an illustrative idea of your score, it may be more beneficial to check your credit report. It’s recommended to check your file once or twice a year (or before you make a finance application) to ensure all recorded information is correct.
Each of the three main CRAs – Equifax, Experian and TransUnion – hold their own version of your credit report. So it’s worth requesting a copy from each of the CRAs via their partner websites: MoneySavingExpert’s Credit Club (Experian), ClearScore (Equifax) and Credit Karma (TransUnion). It’s free to request a copy of your report, and it won’t have any impact on your credit score.
Top tips to minimise the impact on your credit score when applying for a personal loan
Applying for any type of credit, whether you’re taking out a loan, getting a credit card or looking into a mortgage, is a big financial decision. And it can have an impact on your credit score, too, which might affect your ability to borrow in the future.
Here are our top tips to help minimise the impact on your credit score when applying for a loan:
Only apply for a loan when necessary
This is obvious, but you should only apply for a loan if you really need to. It’s never a good idea to apply for finance simply to build your credit history, to top up your nest egg or to help out with day to day living expenses.
Research and compare loan options before applying
Before hitting that ‘apply now’ button, make sure you do your research. Check the lender’s eligibility criteria to make sure you’re only applying for a product you are eligible for, to give yourself the best chance of being accepted.
It’s also a good idea to use the Representative APR (the APR usually advertised on a lender’s website) to compare the cost of borrowing across different lenders. This gives you an idea of the best rate that will be offered to the majority of accepted applicants.
When comparing lenders, try to always use like-for-like scenarios. Look for a quote based on the same amount and term, and take any additional fees or hidden charges into account too.
Limit the number of loan applications you make
It might seem tempting to apply for lots of different loans at all once, and then choose the best option offered to you. However, this can have a detrimental effect on your credit score and could harm your chances of being accepted for a loan.
Try not to apply for too many different financial products within a short space of time either. For example, if you’ve recently taken out a car loan, it’s recommended to wait at least six months before applying for another financial product such as a credit card.
Looking for more advice on personal loans?
Bookmark our Hints & Tips page. Our guides cover everything you need to know about personal loans, APR vs interest rates, the questions you need to ask yourself when applying for a loan and why you should choose Novuna.
Once you think you’re ready to apply for a personal loan, head to our loan calculator to get a quote. With Novuna Personal Finance, you can borrow between £1,000 and £35,000 at low rates from 7.4% APR Representative (£7,500-£25,000).
Sophie Venner is a Yorkshire-based content writer specialising in crafting content for the financial services industry. She’s written over 300 articles on finance, but she’s covered everything from insurance to digital marketing trends. Her content has been featured in the likes of Semrush, Digital Marketing Magazine and Insurance Business. In her spare time, you won’t find Sophie far from a notepad and pen as she squirrels away trying to write a novel.
Wednesday 19th July 2023