Introduction
These days, it is very easy to get a personal loan. You just submit the online application, and within a few hours, the funds are credited to your account. But do you know that personal can directly impact your credit score?
The impact can be negative or positive depending on the credit behaviour of the individual. If you manage the personal loan properly with regular payments, then it can help you build your credit. But if you mismanage it, then it can hurt your credit score.
In this blog, we will discuss the effects of a personal loan on a credit score. By educating yourself on this, you can take better actions that can ensure smooth financial health.
Impact of Personal Loan on Your Credit Score
A personal loan has a positive and negative impact on your credit score. Here is how a personal loan affects your credit score: –
1. Inquiry Related Credit Score Drop
When you apply for a new personal loan, the lender will assess your creditworthiness. For this, they will run a credit check on your name. This is defined as a hard inquiry. This directly affects your credit score. Every time you apply for a personal loan, it will drop your credit score to some extent.
Hence, you should never apply for multiple personal loans in a short period. This will affect your credit score negatively. You should check various personal loan offers and proceed with the one that is best, rather than applying to multiple lenders. This saves your credit score from being affected.
2. Credit Mix Impact
Lender, while evaluating a borrower’s credit profile, does check the credit mix. It is a combination of various credit products you have in your portfolio. Adding a personal loan to your portfolio improves your credit mix. Having different types of credit products in your portfolio, like revolving credit (Credit card) and instalment loans (Personal loans, auto loans, home loans), is always beneficial.
If there are various products in your portfolio, it means that you can handle multiple products efficiently. This makes lenders feel confident about you, and they can offer you a loan on relaxed terms. The healthy credit mix also impacts your credit score, as it is one of the factors that determine your credit score.
3. Lower the Credit Utilisation Rate
You can use a personal loan for debt consolidation. You can get a personal loan at a low interest rate and pay high-interest debt like credit cards. This will reduce your credit balance, and hence your credit utilisation ratio will be reduced. As a result, your credit score improves.
Credit utilisation ratio plays an important role in credit scoring models, too. Revolving credit utilisation can affect 20%-30% of your credit score, depending on the credit scoring model. Hence, it is advisable to keep the credit utilisation ratio under 30% so that your credit score is not damaged.
4. Repayment Track
Your loan repayment track matters a lot in determining how a personal loan affects your credit score. Your repayment history contributes around 35% to your credit score and, hence, is a major factor in credit score calculation.
If you make timely payment of your personal loan EMIs, then it adds to your positive payment history. It helps improve your credit score. On the other hand, missed payments and repeated delays in payment of personal loan EMIs will downgrade your credit score.
5. Closure of Personal Loan
If you make regular EMI payments, then your personal loan will be closed successfully. This will affect your credit score positively. The successful closure of a personal loan reflects your financial discipline. Lenders start trusting you more and may offer you loans at the best terms.
Once the personal loan is closed, its status is mentioned as “Closed” in the credit report rather than ‘Settled”. Hence, you shall always try to close your loan account by proper repayment and refrain from settling the account through non-payment.
6. Debt-to-Income Ratio
When you take a new personal loan, it increases your overall debt. Hence, your debt-to-income ratio increases. This ratio determines the overall debt you owe as compared to the income you earn. It is necessary to manage this ratio as it impacts your credit health.
Conclusion
In this blog, we have studied the effects of a personal loan on a credit score. Personal loans have a great impact on your credit score. If you take a new personal loan, then it can reduce your credit score. However, properly repaying it on time can raise your credit score in the long run.
Adding a personal loan to your financial portfolio can also have a positive impact on your credit score. Do keep your credit utilisation ratio under 30% so that your credit score is not damaged. You should manage a personal loan cautiously. If not done, then your credit score is impacted negatively. And if managed properly, then it can have a positive impact on the credit score.
Also Read: Maintain a Healthy Credit Score Using These Smart Ways
