Understanding the Impact of Credit Checks on Your Credit Score
Few things generate as much concern and confusion when managing your credit as credit checks. Often surrounded by myths and misconceptions, the effect of credit inquiries on your score is a topic worth demystifying. Whether you’re applying for a new credit card, shopping for a car loan, or considering refinancing your mortgage, knowing how these checks impact your credit score is crucial. Let’s dive into the details.
What is a Credit Check?
A credit check, also known as a credit inquiry, is when a lender reviews your credit report to evaluate your creditworthiness. This typically happens when you apply for credit, such as a loan or a credit card. There are two primary types of credit inquiries: hard and soft, each affecting your credit score differently.
Hard Inquiries vs. Soft Inquiries
Hard Inquiries:
Hard inquiries occur when a financial institution checks your credit report as part of a lending decision. These are common when you apply for a mortgage, car loan, or credit card. Hard inquiries can lower your credit score, as they may indicate to creditors that you are seeking new credit lines, which could be a sign of financial risk.
Soft Inquiries:
Soft inquiries happen when a person or company checks your credit report as a background check. This includes checking your credit, employment verification, or pre-approved credit offers. Soft inquiries do not affect your credit score because they do not reflect an attempt to gain additional credit.
How hard credit inquiries impact your credit score in Canada
When you apply for financing, a hard credit inquiry is initiated, requiring a lender to evaluate your creditworthiness for loan approval.
This review process is essential for lenders to assess how well you manage your finances. It involves accessing your credit history to make an informed decision about your loan application.
Typical situations that trigger hard credit inquiries include:
– Applying for a mortgage
– Applying for new credit cards
– Taking out student loans
– Securing personal loans
Submitting applications for various loan types in a short timeframe can lead to multiple inquiries being recorded on your credit report, signalling potential financial strain to creditors. This perceived risk can negatively affect your credit score, as credit reporting agencies may deem you less likely to repay borrowed funds. Thus, it’s advisable to apply for credit judiciously and choose lenders who are more likely to offer approval.
Strategizing to Lessen Inquiries’ Impact
A notable exception exists for accumulating multiple applications within a brief period: if you’re rate shopping for a specific loan type, such inquiries are consolidated into a single inquiry.
For instance, while scouting for a vehicle, you may inquire about auto loan rates from various lenders. Although each lender conducts an inquiry, if all occur within a designated 45-day timeframe, they are amalgamated into a singular inquiry. This aggregation suggests prudent shopping rather than indiscriminate loan applications.
Duration of Hard Inquiries on Credit Reports
Each hard inquiry slightly reduces your credit score and can influence it for up to a year, though it remains on your report for three years.
Applying for a diverse mix of loans (e.g., personal loan, credit card, mortgage, auto loan) within a short span can quickly cumulate multiple hard inquiries, amplifying lenders’ risk perception. This heightened risk can result in a diminished credit score and possibly higher interest rates.
Thus, applying for credit only when necessary is beneficial. It ensures that any hard pulls on your report reveal responsible financial behaviour rather than potential credit mismanagement.
How soft credit inquiries impact your credit score
Lenders conduct soft inquiries for non-lending reasons and do not affect your credit score or appear on your credit report.
Such checks are performed for informational purposes and are common in situations like:
– Employment background checks
– Insurance application assessments
– Pre-qualification processes for car loans or credit cards
Since soft checks are not associated with a direct application for new credit, they do not influence your credit score, ensuring any penalty for these inquiries.
Checking your own credit report through major credit bureaus in Canada, such as Equifax or TransUnion, also falls under soft inquiries, as it does not involve a loan application process.
How Much Can Credit Checks Affect Your Score?
The impact of a hard inquiry on your credit score varies based on your overall credit history, though it’s generally less significant than one might fear. For most people, a single hard inquiry might lower their credit score by five points or fewer. However, the specific impact depends on the individual’s credit profile. Those with few credit accounts or a short credit history may see a more significant impact from a single inquiry.
Multiple hard inquiries in a short period can be more damaging. Yet, to allow for rate shopping, credit scoring models often count inquiries for certain types of loans (auto loans, student loans, mortgages) as a single inquiry if they occur within a short period (usually 14-45 days, depending on the scoring model).
Rate Shopping and Its Impact
When you’re shopping for the best rates on loans, especially for mortgages, auto, and student loans, lenders will typically make hard inquiries to offer you accurate rates. Credit scoring models recognize this behaviour and are designed to consider multiple inquiries for the same type of credit within a specific timeframe as a single hard inquiry. This provision allows you to shop for the best rates without worrying about significant damage to your credit score.
Minimizing the Impact of Credit Checks
To mitigate the potential impact of credit inquiries:
1. Limit New Credit Applications: Apply for new credit accounts only when necessary.
2. Rate Shopping Window: Take advantage of the rate shopping window by completing your loan inquiries within a 14 to 45-day span.
3. Regularly Monitor Your Credit: Check your credit report regularly for accuracy and to understand how different actions affect your score.
4. Build a Strong Credit History: A robust and positive credit history can help minimize the impact of individual hard inquiries.
The Bottom Line
Understanding the nuances of how credit checks impact your credit score can help you make more informed decisions about when and how to apply for credit. While hard inquiries can slightly lower your credit score, their effect is often minimal and temporary. Being strategic about applying for new credit and utilizing rate shopping windows can help you minimize the impact on your score. Remember, maintaining good credit habits, such as paying bills on time and keeping balances low, will always be vital to achieving and sustaining a healthy credit score.