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Comparison shopping is a proven way to get the best deals on whatever you need. That "need" may be a hotel room, a new TV, a credit card, or anything else along those lines. When it comes to loans though, shopping around can actually do significant damage to your credit score, depending on how you go about the process. I saw a 60+ point drop in my score years ago because of this…no lie. If you know what to watch out for and how to avoid it, you can still find the best option without sacrificing your future borrowing power.
Here is a guide that explains what may happen to your credit score with loan shopping and what you can do to keep it up.
What Happens to Your Credit
While it is always a good idea to shop around for the best loan rates and terms, it can also be a fast path to a lower credit score. That's because each time you apply for new credit, a lender orders a copy of your credit report (also known as a "credit pull" or "credit inquiry"). Once that's done, the action is reported to all of the major credit bureaus. It eventually winds up being calculated into your FICO score – the all-important number than determines your credit rating. Rather than helping your score, it lowers it. That is why you should carefully avoid the practice of applying for credit all over town.
Why That Happens
To many consumers, this adverse outcome makes no sense because applying for credit really has nothing to do with your ability to repay debts in a timely and responsible fashion. While that is certainly true, lenders view the scenario from a completely different perspective. When lenders and credit reporting agencies see a person applying for loans from multiple banks or loan companies, they automatically perceive the person as desperate. Desperation greatly limits your financial trustworthiness.
If you are filling out lots of different loan applications simultaneously, lenders believe that it is because you expect that most of them are going to be turned down. They assume that in order to improve your chances of securing a loan, you are applying everywhere in the hope that one of the lenders will not reject you. While that may not be true, lenders assume the worst and view this kind of activity as high-risk borrower behavior. That translates into a lower credit score and it can torpedo your chances of getting a loan.
How to Avoid Getting a Low Score
When I started looking for my first car, no one told me about this downward spiraling effect. I had a score in the 700s by the time I was 19, but that dropped to the low 600s just because of credit pulls. Here's what I learned from all of that:
Let Time Pass
The first thing I did when I saw my score drop was stop applying for loans. Once you have a decent stretch of time between applications, you can start browsing around again. I waited at least a year before applying for another loan, and that decreased my desperation factor significantly. You have to give your credit time to heal.
Interview Your Lenders
I didn't just start applying for loans right away. I learned to ask questions beforehand. I always talk to the finance director of whatever place I am working with to see if I have a good chance at getting a loan at all. If I am a no-go from the start because of my job, income, credit history, age, etc., I move on without risking the credit pull. Ask the right questions early on, and you can bypass a lot of unnecessary apps.
Note that when you start asking people about rates, fees, and other costs, they are going to tell you that it's impossible to predict those features. That's true, but if you press them hard enough, they can give you ballpark figures or tell you how likely you are to get a loan. I'm self-employed, and a lot of lenders have a problem accepting that. Thus I rule out a lot of banks just by asking if my work history is worthy enough of a loan, credit card, etc. You have to narrow your options so you can minimize your inquiries. As long as the lender does not pull your credit report, you're fine.
Do Your Research
You may have to put in a little work to find the best possible lender to work with. I know that my current credit situation is pretty rough (medical bills piled up after a car accident). Thus I stick to lenders that work with less-than-perfect credit scores. If you have no credit at all, you'll need a lender that can handle that. Talk to people you know who have loans or credit cards and see what experiences they have with different creditors. Then you can determine where you might want to go.
Other Theories to Consider Some places say that applying for multiple loans of the same type will only put one mark on your credit, rather than a dozen. In other words, if you apply for 5 car loans within a day or two of each other, they may only show up as one hit. However, if you apply for an auto loan, a home loan, a business loan, a personal loan, and a credit card in one or two days, you're going to have five hits on your credit. If you want to trust this theory, chunk your loan apps together and avoid getting too much too quickly.
Next time you go to the mall and the clerk offers you a 10% discount for applying for the store's new credit card, think twice. The $10 you may save will cause a hit on your credit report, which could lower your credit rating and cost you thousands of dollars in future loans. Is that really worth the slightly cheaper pair of shoes you get? Shop around for loans without putting your information out there, and you'll be able to preserve the score you're trying to build.
Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any card issuer.