A personal loan can affect your credit score in both good and bad ways. But, contrary to popular belief, taking a personal loan is not bad for your score. In fact, by taking a personal loan and repaying it on time, you can boost your credit score and build a trustworthy credit history.
In this guide, we walk you through how taking a personal loan can benefit your credit score and share tips on using personal loans smartly to build a stellar credit history.
What goes into your credit score?
To better understand how a personal score impacts your credit score positively, we first need to know how the credit score is calculated. In India, credit scores for individuals are computed by authorised credit agencies like Equifax, Experian, TransUnion CIBIL and CRIF.
The scores range from 300 to 900 and are calculated based on five key factors:
- Payment history – based on how regular you are with your credit payments
- Outstanding debt – based on the total amount of outstanding debt you owe
- Length of your credit history – how long you’ve been using credit
- Credit mix – Mix of secured and unsecured loans
- New credit – based on whether you have applied for any new credit
The exact percentages of these factors vary based on the internal algorithm of each credit bureau. All four major credit bureaus offer credit scores based on the creditworthiness of an individual, but there may be slight differences.
Does applying for a personal loan affect my credit score?
As you can see, obtaining a new loan – be it a personal loan, a credit card, or any other type of loan impacts your credit rating. For example, when you apply for a new personal loan, it directly impacts two of the five factors listed above:
- New credit – a hard inquiry is raised by the lender before sanctioning your personal loan.
- Outstanding debt – your overall debt increases due to the loan, and it shows that you have acquired new debt on your credit report.
It is be noted that credit bureaus record all credit-related activities of an individual. Besides the loan amount, the frequency of loan applications also plays a role in determining your credit score. For example, if you apply for a personal loan immediately after taking a home loan and a car loan, your application for the personal loan may be rejected due to several debts.
Does that mean taking a personal loan is bad for my credit score?
Not at all. Your overall credit history has a bigger impact on your credit score than a single new loan. For example, if you have a track record of managing debt properly by repaying loans and credit card bills on time, the temporary impact of a new personal loan is likely to be very less.
Taking a personal loan and repaying it on time can help in boosting your credit score. Let’s take a look at the positive impacts of a personal loan on your credit score.
Ways in which a Personal Loan can Help your Credit History and Credit Scores
Depending on how you handle personal loans, they can help in boosting your credit score in several ways.
- It helps you build a credit history from scratch – If you have not taken any loans, your credit history is a blank slate. This doesn’t work in your favour, especially when you’re applying for new loans or credit cards. By taking a personal loan and repaying it on time, you build a good repayment history recorded in your credit report. Besides helping you build your credit score, this also helps demonstrate your ability to repay loans on time to future lenders. This is a huge benefit, especially if you’re planning to apply for bigger loans in the future like home loans, etc.
- It improves your credit mix – As mentioned above, the credit mix plays a significant role in impacting your credit score. Having a balanced combination of different types of credit:
- Secured loans (like home loans, car loans, two-wheeler loans)
- And unsecured loans (like personal loans, credit cards)
It shows lenders that you can handle different types of credit responsibly. If your portfolio has only secured loans, then taking a personal loan helps balance it out, which improves your credit score.
- Builds a Positive Payment History – Repaying home loan EMIs on time helps you establish positive repayment history. Your timely repayments are recorded by the credit bureaus, which in turn significantly boosts your credit score.
- Lowers the Credit Utilisation Ratio – Since a personal loan is an instalment loan (one-time loan amount disbursement and monthly repayments in the form of EMIs), the loan amount doesn’t factor into your credit limit. You can use the loan amount to handle emergencies instead of using your credit card. This way, your credit utilisation ratio is reduced, which in turn improves your credit score in a positive way.
Personal Loans and Credit Scores
From a credit rating perspective, using a personal loan to meet emergencies is a much better choice than using your credit card. This is because of the following advantages of a personal loan:
- Competitive interest rates
- Bigger loan amount
- Reduces credit utilisation ratio
- Improves your credit mix
- Builds a strong repayment history
The Bottom Line
The key is repaying the loan on time
A personal loan is a double-edged sword. It offers various benefits, provided you handle it responsibly. Taking a personal loan can cause your credit score to drop by a few points temporarily. However, by repaying the loan on time, you can use the loan to boost your credit score in the long run, improving your eligibility for securing bigger loans and premium credit cards in the future.
If you decide to take a personal loan, make sure to research and compare the best loan offers in the market. Using a loan aggregator like CreditMantri gives you the list of all best personal loans matched to your credit profile. You can then compare and choose the best loan for your financial situation.
Key Takeaways
- Taking a personal loan can affect your credit score in both good and bad ways.
- You may notice a temporary drop in your credit score as soon as you apply for the loan.
- However, by repaying the loan on time, you can boost your credit score and build a stellar credit history over time.
- Handling the loan repayments on time positively affects your credit score, as it demonstrates that you can handle debt responsibly.