Whenever a person applies for a loan, lenders check the credit score of that person. Credit Score becomes one of the most important criteria for getting any loan. As a result, most people look for ways to improve their credit scores.
Many people think that taking a personal loan hurts their credit score. But this is not true. Personal loans can either improve your credit score or lower your credit score. It all depends on how efficiently you use your loan.
When taking a personal loan, lenders make hard inquiries about your credit score. These hard inquiries hurt your credit score. Additionally, the new loan reduces the average age of your credit accounts, resulting in a decrease in your credit score.
However, if you repay all your dues on time, it will increase your credit score.
Therefore, if you do not manage a personal loan properly, it can harm your credit score. However, if you manage your loan responsibly and repay all your dues on time, it will significantly improve your credit score.
How does applying for a personal loan affect your credit score?
When you apply for a personal loan, lenders make hard inquiries about your credit score. These hard inquiries lower your credit score slightly. After your loan application is approved and you get the loan, your credit score again goes down as the new loan reduces the average age of your credit. However, if you manage your loan responsibly and repay all your dues on time without any defaults or delays, your credit score will improve substantially.
How can a personal loan improve your credit score?
When you manage your loan effectively, it can improve your credit score.
Credit Utilization Ratio:
Your credit utilization ratio is one of the most important factors in calculating your credit score. When you take a new loan, your credit limit increases which significantly reduces your credit utilization ratio and improves your credit score. However, taking a new loan or credit card will initially lower your credit score due to new inquiries and lower average age of your credit accounts.
Credit Mix
Having a diversified portfolio of credit accounts reflects your responsibly handling various financial obligations. This mix of diverse loans is good for your credit score.
If you are responsibly managing different types of loans and repaying all your dues on time, your credit score will improve significantly.
Payment History
Your payment history to date is one of the most important factors in determining your credit score. If you repay all your dues on time, it will significantly improve your credit score. Taking new additional loans and repaying all your dues on time adds to your positive payment history and helps improve your credit score.
How can personal loans hurt your credit score?
As discussed above, managing personal loans improperly hurts your credit score. There are several other ways personal loans can hurt your credit score.
Hard inquiries
When you apply for a loan or credit card, lenders run a hard inquiry on your credit report. This can cause a slight, temporary decrease in your credit score.
Additional loans
When you take additional loans, it increases your total debt. More debt reduces lenders’ trust in you. Suppose your monthly income is Rs.1,00,000/- and your current EMI is Rs.25,000/-, which is 25% of your income.
Now if you take an additional loan with an EMI amount of Rs.15,000, your total EMI will be Rs.40,000/-, which is 40% of your income. Since the total EMI is 40% of your income, it will become difficult for you to manage all your other expenses from your remaining income. Hence, lenders will hesitate to lend you any loan.
Additional payments
Additional loans mean additional EMIs. These additional EMIs can become a challenge for your monthly budget. It will be very difficult for you to deal with this challenge every month and any missed or late payment will significantly lower your credit score.
Conclusion
A personal loan can help you improve your credit score if you manage your loans responsibly. However, if you mismanage your loans, it can also lower your credit score.
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