Personal loans are unsecured loans that you can use for various purposes, from consolidating debt to covering unexpected expenses. They can positively or negatively affect your credit score depending on how you manage them. Personal loans from reputed banks can significantly impact your credit score in various ways. Let’s dive into the nitty-gritty of how these loans can affect your credit score and overall financial health.
How can A Personal Loan impact your Credit?
1. Credit Inquiry
When you apply for a personal loan or any form of credit, the lender typically checks your credit report.
Soft inquiries: Soft inquiries, such as when you check your own credit or when a company does a background check, don’t affect your credit score.
Hard Inquiries: Hard inquiries occur when you apply for credit, and they can have a slight negative impact.
Impact: Each hard inquiry may lower your credit score by a few points, typically around 5-10 points, but this impact is temporary.
Duration: Hard inquiries remain on your credit report for about two years but only affect your score for the first year. Over time, their impact diminishes.
Multiple Inquiries: If you apply for several loans or credit cards within a short period, it raises red flags for lenders. It might suggest you’re in financial distress, causing concern about your ability to manage more debt. This can further reduce your score.
2. Credit Mix and New Credit
Diversity Benefits: Lenders prefer to see a mix of credit types on your report, such as revolving credit (like credit cards) and instalment credit (like personal loans or mortgages). This mix can showcase your ability to manage different types of credit responsibly.
Impact on Score: Having a variety of credit accounts can positively impact your credit score. If you primarily have credit card debt, adding an instalment loan like a personal loan diversifies your credit profile, potentially boosting your score.
3. Timely Payments
Weight on Credit Score: Your payment history contributes significantly to your credit score, often accounting for about 35% of the score calculation. This history includes payments for credit cards, mortgages, and loans like personal loans.
Positive Impact: Making on-time payments on your personal loan consistently shows lenders that you’re reliable and can manage debt responsibly. This practice can boost your credit score significantly over time.
Impact of Missed Payments: Missing payments or defaulting on a personal loan can have severe repercussions on your credit score. Late payments can stay on your credit report for up to seven years and significantly lower your score, making it harder to obtain credit.
4. Credit Utilisation Ratio
Revolving vs Instalment Credit: Credit utilisation is the ratio of the credit you’re using to the credit available to you. It mainly pertains to revolving credit accounts, such as credit cards.
Impact on Credit Score: High credit card balances relative to your credit limits can negatively impact your credit score. Credit scoring models typically view lower utilisation ratios positively.
5. Personal Loans and Utilisation
Instalment Loan Impact: Personal loans are instalment loans, and they don’t directly impact your credit utilisation ratio because they don’t have a credit limit that you draw from repeatedly, like credit cards.
Debt Consolidation Impact: However, using a lowest personal loan interest rate to pay off high credit card balances can indirectly lower your credit utilisation ratio. By consolidating credit card debt into a personal loan, you decrease the revolving credit’s outstanding balance, potentially boosting your score.
6. Length of Credit History
Credit History Impact: The length of time your credit accounts have been open plays a role in determining your credit score. A longer credit history generally portrays a more comprehensive picture of your credit management habits.
Initial Impact of New Account: When you take out a personal loan, it can initially shorten your average account age because it’s a new credit account. This short-term reduction might have a slight negative impact on your score.
7. Positive Contribution Over Time
Long-Term Benefits: As you continue making on-time payments on the personal loan and it ages, it starts contributing positively to your credit history. Over time, the loan becomes an established and positive part of your credit profile, potentially boosting your score.
8. Paying Off the Loan and Closing the Account
Available Credit Reduction: When you successfully pay off a personal loan, it might seem logical to close the account. However, closing a paid-off account reduces your available credit, potentially increasing your credit utilisation ratio if you have other outstanding balances.
Credit History Impact: Additionally, closing an account can shorten your credit history’s average age, especially if it was one of your older accounts. This reduction might have a negative impact on your credit score.
Weight of Factors: While closing a paid-off account might seem like a good idea, consider the potential impact on your credit utilisation ratio and average account age. Sometimes, keeping the account open, especially with no annual fees, can benefit your credit score.
9. Debt-to-Income Ratio
Calculation: Your Debt-to-Income (DTI) ratio is a measure that compares your total monthly debt payments to your gross monthly income. It is computed by dividing your overall monthly debt payments by your gross monthly income, presented as a percentage.
Significance: Lenders use DTI as a crucial factor in determining your ability to manage additional debt responsibly. A lower DTI is generally favourable as it indicates that you have more income available to cover your debts.
10. Impact of New Personal Loan on DTI
Adding New Debt: Taking on a new personal loan increases your total monthly debt obligations, potentially raising your DTI.
Impact on Future Credit: A higher DTI might affect your ability to qualify for additional loans or credit cards in the future. Lenders often have DTI thresholds, and exceeding these limits can signal to them that you might be overextended and unable to take on more debt responsibly.
Conclusion
Personal loans can significantly impact your credit score and financial well-being. By making timely payments, diversifying your credit mix, and being mindful of how they affect your overall debt profile, you can use personal loans from banks to strengthen your creditworthiness.
However, mismanaging these loans by missing payments or taking on too much debt can have adverse effects on your credit score and overall financial health. It’s crucial to weigh the benefits against the potential risks before applying for a personal loan and to manage it responsibly once obtained.
