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How Loans Build and Sink Credit Scores

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Some people treat debt like the bad kind of four letter word. While debt and loans can be harmful, they can also be helpful when it comes to establishing a credit history and score. Understanding how loans build and sink credit can help you make smart financial choices, either to get your current debt under control or to establish credit for the first time.

Build: Paying On Time

Your payment history is one of the more important components when it comes to credit, according to the Fair Isaac Corporation (FICO), which calculates the scores used by many lenders. If you consistently pay the amount due on your loans on time, they can help build your credit.

How can you make sure that you always pay on time? The easiest way is to set up automatic payments, so that the amount due comes out of your bank account on or before the due date. Another thing to consider is whether you can afford the monthly payment or not. Making timely payments means being able to afford the cost of the loan each month after you’ve paid your other bills.

Sink: Owing a Lot

Taking out a lot of loans or carrying a balance on a lot of credit cards can signal to lenders that you’re more of a credit risk and potentially sink your credit. How much debt is too much debt really depends on the amount you borrow each month, the amount of credit available to you, and the amount of the original loans. For example, if you have three credit cards, each with a limit of $5,000, and your balance on each of the cards is $2,500 at the end of the statement period, you’re using 50 percent of the credit available to you, which can be a red flag. If you have seven open accounts and they all have a balance, those number of balances can also negatively affect your score.

It’s worth noting that the amount you owe on your loans is compared to the amount you could borrow or the amount initially borrowed when companies like FICO determine your score. Agencies that figure out scores don’t use your income when determining whether you’ve borrowed too much or not. But, a lender might also look at your income in comparison to what you owe and use that ratio to decide whether or not to give you another loan, too.

Build or Sink: The Length of Credit History

Part of understanding how loans build and sink credit is understanding how they impact the length of your credit history. A credit scoring company figures out the average age of all your accounts when calculating your score. Older is better. Having a loan for years and making consistent payments can be a good thing for your score --- it shows lenders that you’ve been able to repay over the long haul.

While applying for new loans or new credit cards won’t necessarily drop your score, or won’t drop it for long, opening a series of new accounts, one right after the other, might. If you have just one older loan and then apply for a number of new loans in a short period, the average age of your credit history will fall, which can potentially sink your credit.

You do want to think about how loans will impact your credit score before applying for one. But, more importantly, you want to consider how the loan will fit into your life and if you’ll be able to repay it without trouble.

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