At every stage in your life, you have different financial needs. Changes in your financial goals or circumstances can lead to you needing new credit. Is new credit a good idea? Are credit applications bad for a credit score, and what impact do they really have? It depends.
To understand how new credit applications affect your credit score, it’s essential you know how a credit score is calculated.
Although new credit or inquiries only comprise about 10% of your score (depending on which scoring model is used), they affect significant aspects like credit utilization and length of credit history. You’ll find a more detailed explanation about new applications and how to use them while maintaining good credit below.
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What is a credit inquiry?
An inquiry happens when a lender asks you to authorize a credit check during a new credit application. Before giving you new credit, a lender checks your credit report and score to see whether you’re a responsible borrower.
Lenders usually use one of the three major credit bureaus (Experian, Equifax, or TransUnion) to carry out an inquiry. At this point, they do what’s called a “hard inquiry” or “hard pull”. Based on the health of your finances, the lender will approve or deny your credit request. In some cases, such as with mortgage applications, the lender will check your credit through all three bureaus. This is known as a tri-merge credit check.
Impact of new inquiries on your credit score
New inquiries leave a small and temporary dent in your credit report and score. All hard inquiries are listed on your credit report for two years, but FICO only looks at inquiries carried out in the past 12 months.
What impact does a new inquiry have on your score? It varies depending on several factors. Aside from the inquiry itself, FICO also looks at;
- the number of accounts you’ve recently opened
- how much time passed since you opened your last account
- amount of time since your last inquiry
Based on such factors, someone with a long and varied credit history could experience lesser impact than someone with a short credit history. Likewise, an individual who waits two years to open a new credit card account may not see as much of a dip as someone who only waited three months.
As a general rule of thumb, your score can drop between 6-12 points after a new credit inquiry. The good news is it’s a temporary hit that should fall off within a year or sometimes earlier. And, like most things in credit, the impact of these checks on your score decreases over time. So, an inquiry made seven months ago has less of an impact than one made last month.
That said, you need to consider how new credit affects two other aspects of your score; length of history and credit utilization.
Length of history
Length of credit history looks at how long a specific account has been open and comprises 15% of your FICO score. Lenders want to see a track record of you paying balances on time, so the longer your credit history the better.
When you apply for new credit, a disadvantage is it lowers the average age of all your accounts. If you don’t have a long credit history to begin with, this can set you back. This shouldn’t deter you from taking out new credit — it’s just useful information to help you plan ahead.
Credit utilization makes up a large 30% of your score. For this reason, taking out new credit can be beneficial or harmful to your score depending on how you use it.
How can it be beneficial? If you’ve been maxing out your credit cards and using over 30% of your available credit, it can help increase your available credit and lower your credit utilization ratio (the percentage of current available credit you’re using).
Let’s say you have two credit cards with credit limits of $2,500 and $7,500, bringing your total available credit to $10,000. If you spend $1,500 on the first card and $3,000 on the second (a total of $4,500), your utilization ratio would be 45%. Seeing as finance experts recommend keeping your utilization below 30%, this would negatively impact your score.
Say you then opened a new credit account with a credit line of $5,000, your available credit would increase to $15,000. If you keep your total balance at $4,500, your utilization ratio would drop to 30%, which is a sweet spot. Assuming you have good payment history among other things, this could boost your score.
On the contrary, increasing your total available credit to $15,000 and spending over 30% or $4,500 will put you back in a bad position or even worse. This information shouldn’t deter you from opening new accounts. On the other hand, be intentional and keep your credit score goals in mind when applying.
Credit inquiries that don’t affect your credit score
Not all credit inquiries affect your score. These are usually referred to as soft inquiries as they have no impact on your credit score whatsoever. What are some examples?
- Background checks
- Employment credit checks
- Credit counseling agency inquiry
- Checking your credit score
- Pulling your free annual credit report
- Insurance credit checks
- Checks for pre-approved credit
- Government or court inquiries
- Utility related inquiries
Rate shopping and your credit score
So, what happens if you’re shopping for a mortgage or auto loan and want to get the best deal? Will doing so hurt your credit score further?
You can have multiple inquiries without it being catastrophic for your score. The goal should be to make all inquiries within the same time window. When you make similar inquiries for the same type of credit within 14-45 days, it’s sometimes counted as a single inquiry. However, there are different types of credit scoring models, so it depends on which they use. Also keep in mind that this only applies to mortgages and auto loans, not to personal loans or credit cards.
Since not all credit inquiries affect your credit score, it doesn’t hurt to ask the lender what type of inquiry they’re going to do beforehand. That way you’re aware and can decide if you want to move forward with the inquiry or not.
Other things you can do are;
- Research the lender before applying for new credit
- Try to only apply for one credit type at a time e.g. don’t apply for a credit card and auto loan simultaneously
- Make sure there are no mistakes on your credit report to avoid get denied and wasting inquiries
The benefits of new credit
New credit can help your FICO score if it diversifies the types of credit you have. For example, if you only have credit cards but take out a car loan, this could boost the credit mix (10% of FICO score) factor of your score.
However, be careful not to open too many new accounts at once; it can make you look like a risky borrower, especially if you don’t have a long credit history.
Also, know the type of credit you take out shouldn’t make a difference to the impact. For instance, a personal loan shouldn’t have more of an effect on your score than a credit card.
So, what should you do with all this information? Here are a few things to keep in mind next time you get ready to open a new credit account.
- Shop around for quotes for similar credit types within the same timeframes
- Avoid opening too many accounts at once
- Keep your overall utilization below 30%
- Space out time between opening accounts
- Diversify the types of credit accounts you open
- Research prospective lenders beforehand to avoid unnecessary inquiries