How loan applications hurt your credit score

Dear Credit Score Report,Let'ssay you go to your bank and request an application for a $50,000 home equityloan. The bank checks your credit and informs you that you are able to get thisloan. However, you decide against the loan and do not follow through. How doesthis affect your credit score? I know there is such a thing as a "soft hit."What would this do to your credit rating? Please advise. Thank you. -- Marcy

Hey Marcy,That home equity loan application will result in a "hardhit" or "hard inquiry" and can impact your credit score, regardless of whetheryou actually get the loan. But don't worry: Any resulting score damage islikely to be minor and temporary.

When you apply for a home equity loan or anothertype of loan, the lender reviews the borrowing history listed on your credit report to determine whether you are a good loan risk or not. Whether or not you get approved for the loan, that credit check still resultsin a notation on your credit report. That notation is what separates a "hardhit" from a "soft hit." (For so-called "soft hits" -- such as when you check your own credit report for errors -- no such notation is made.) It signals thatyou are a borrower in search of credit and allows credit scoring models (and potentiallenders) to treat you accordingly.

Since scoring models view a sudden desire for money as apossible sign of a borrower in financial trouble, your credit score may dip. However,as long as you've borrowed responsibly in the past and continue to do so, anycredit score damage should be minor and your score will recover quickly. Thatmeans "there may be little or no impact in terms of her ability to qualifyfor other credit," says Rod Griffin, director of public education for credit bureau Experian.

Here's another way to visualize the difference between thetwo inquiry types: Imagine a hard inquiry as a pellet gun and a soft inquiry asa Nerf gun. A soft inquiry -- like the foam pellets from a Nerf gun -- justbounces off your credit report and causes no damage. A hard inquiry -- like ametallic BB -- may sting and leave a temporary mark, but likely poses no realthreat to someone in good financial health.

What kind of mark will it leave? "For most people, anadditional inquiry will take about five points or less off of theirscore," says Barry Paperno, consumer operations manager at myFICO.com, theFICO score creator's consumer website. That's not enough of a drop to causeconcern for most borrowers. Still, you can multiply the impact when you applyfor several credit cards or loans around the same time. That's a good reason to avoid seekingcredit you don't really need -- especially around the time you plan to applyfor a major loan, such as a mortgage or car loan, where losing even a few credit score points could mean a higherinterest rate.

A soft inquiry, meanwhile, is strictly performed forinformational or promotional purposes. Since that type of credit check doesn't result in you taking on additional debt, your score won't be affected. Asoft inquiry can occur in the following situations:

When you review your credit report.
When your existing bank takes a look at your credit report.
When banks or businesses look at your report when deciding whether to pre-qualify you for certain marketing offers.
When a potential employer checks your credit report as part of its hiring process.
When an insurance company looks at your credit report.

In the scenario you describe, if you applied for the home equity loan, your credit score would indeed be impacted by a hard inquiry -- whether you continued with the loan request or not. However,you can apply for more than one home loan within a given time frame withoutincreasing the score impact, which is not possible with multiple credit cardapplications.

As with mortgage or autoloans, the FICO scoring model recognizes that several home equity loanapplications occurring close together suggest a borrower is looking for thebest possible loan and will eventually choose just one. When multipleinquiries from home equity loan "applications are incurred within a short time, such as 45days, they are treated as a single inquiry by the FICO formula," Papernosays. That's similar to how car loans are treated on your credit report. "Forexample, a consumer goes to six car dealerships within a 30-day period lookingto buy a car and their credit report is pulled each time. This would be viewedas one hard inquiry to the consumer's credit report," says Cliff O'Neal,senior director of corporate communications for credit bureau TransUnion.

So what's the lesson here? As long as you always pay billson time, keep debt levels low and apply for new credit only when absolutelynecessary, your credit score isn't in any real danger from a hard inquiry. Andif you aren't happy with the home equity loan terms offered by the first bank, from ascoring standpoint, it's usually safe to keep shopping.

--Jeremy

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