Most people know that applying for credit too much can hurt your score. Beyond that, however, few people really understand how credit inquiries affect (or don't affect) your credit score.
In reality, only certain types of inquiries count, and those that do aren't likely to affect your credit score too much. And there are credit scoring rules in place that encourage you to get the best interest rates possible.
What is an "inquiry"
Essentially, an inquiry is when someone (including you) checks your credit for any permissible purpose. And these inquiries come in two main varieties.
A "soft inquiry" is an inquiry by a creditor or other agency for a permissible purpose that you may or may not initiate. This category also includes when you check your own credit. Common examples include when a credit card issuer wants to preapprove you for a credit card offer, or when one of your existing creditors wants to check your score in order to decide whether to raise your limit or not. Soft inquiries may be visible on your credit report, but they're not factored into your score.
"Hard inquiries" are the only kind you need to worry about for scoring purposes. These are inquiries that you initiate when you apply for new credit or ask your creditors to increase your limit or modify your account. So how much of an impact will one of these inquiries have on your credit?
It's also important to note that some inquiries can be either hard or soft, depending on the situation. Some examples include when you apply to rent an apartment, open a checking account, or apply for a cellphone contract.
How will a hard inquiry impact your score?
The short answer is "not much." A single inquiry is unlikely to have a significant impact on your credit score.
The actual effect of a single inquiry depends on a person's unique credit history. It can vary, but in my personal experience, the largest inquiry-caused move I've ever seen was a four-point drop, and myFICO.com says an inquiry will usually cause less than a five-point impact. Hard inquiries remain on your credit report for up to two years, but your FICO score only takes into account those inquiries from the previous 12 months.
Even though a single inquiry is unlikely to make any significant difference in your credit score, a lot of inquiries could become a problem. If the average inquiry lowers your credit score by three points and you apply for a handful of new credit cards, an auto loan, a personal loan, and a mortgage over the course of a year, it could have a pretty substantial impact on your score.
The point is that so long as you apply for credit sparingly, you don't need to worry too much about inquiries. However, an excessive number of credit inquiries can have a much more serious impact on your score.
Don't be afraid to shop around
One consumer-friendly aspect of inquiries is the "rate-shopping" guidelines that are used when determining the FICO score. Basically, consumers are encouraged to shop around for the best interest rates on mortgages and auto loans without fear of multiple hard inquiries bringing down their credit score.
If you're applying for a mortgage or auto loan, all credit inquiries that take place within a "typical shopping period" count as a single inquiry. The shopping period varies from 14 to 45 days, depending on which version of the FICO scoring model each lender uses, so it's best to err on the side of caution and do your rate-shopping within a two-week period.
So, if you apply for a mortgage with 20 different lenders over the course of two weeks, your credit score will only be affected by one hard inquiry.
It's a small piece of the puzzle
When you consider that "new credit" information makes up just 10% of the FICO scoring formula, and inquiries make up just a portion of that, it puts the credit inquiry "myths" in perspective.
So, if you want a new credit card because it has lower rates or better rewards, go for it. Or if you want to see whether you can qualify for a special interest rate on a new car, by all means, do so without fear of a massive credit score drop. Your credit is there to help you save money and get the best interest rates, and so long as you don't go overboard with credit applications, the fear that an inquiry or two will hit your credit shouldn't prevent you from taking advantage of your credit.