A personal loan is a simple short-term loan that could be used for any legitimate purpose. It’s an unsecured loan, so you won’t have to put up any kind of collateral or security. It can be used to cover unexpected personal needs such as a medical emergency or a job loss, to support your wedding or higher education, and, finally, as a capital for a company or debt consolidation.
A personal loan has a number of benefits, including easy documentation, no requirement for collateral, and no restrictions on how you spend the money. It does, however, come with a high interest rate, therefore having a decent credit score is recommended before applying for it.
Even if you don’t plan on taking out a loan anytime soon, checking your credit score is an excellent habit to get into. It’s likely that you’ll need a loan in the future, and keeping track of and improving your credit score will offer you the best benefits in the long run.
Personal Loan and Its Impact On Credit Score
Your credit score is calculated using the proprietary algorithms of each credit bureau. But the key elements deciding your credit score are the same:
- Credit history
- Credit utilization
- Credit history length
- Credit mix
- New credit
Personal loans are helpful with your credit utilization: Personal loans are better than credit cards as they reduce your credit utilization ratio and boost your credit score.
The amount of revolving credit you’re now utilizing divided by the entire amount of revolving credit you have available is your credit usage rate, also known as your credit utilization ratio. That is to say, how much you owe at present to your credit limit. It is expressed commonly as a percentage.
A personal loan lowers your credit utilization ratio and enhances your credit score. When you put all your debts on a credit card, you are choking the credit utilization ratio which is very bad for your credit score. So, when you get a personal loan, your credit utilization ratio frees up a bit, enhancing your credit score.
Improves your credit history: Another factor affecting your credit score is your repayment history and credit history. Unlike credit card bills, personal loans go on for a few years, thus improving your credit history. Also, a good repayment history ticks all the right boxes for a good credit score. Lenders are eager to find borrowers who have an impeccable repayment record. This improves your chances of getting future loans with better terms and interest rates.
Boosts your credibility: Any loan can boost your credit score if paid on time. The key here is paying on time every time. A personal loan that is paid back on time might help you improve your credit score by demonstrating that you can manage debt responsibly. You need to remember, establishing your credibility is also important to improve your chances for future loans.
Enhances your credit mix: In the credit rating calculation, a credit mix is a critical factor. Credit mix refers to the diversity of the many forms of loans or lines of credit you are currently repaying or have previously repaid. Adding a personal loan to the mix can help you enhance your credit score by demonstrating that you have dealt with a variety of credit kinds previously.
Can be a good option for debt consolidation: You could take out a single personal loan to consolidate your existing financial liabilities so that you can pay them off and just have a single loan. This will lower the amount of interest you pay on your debt while also ensuring that you repay your personal loan in a timely manner via EMIs. If you consider the effect it has on your credit score, you are going to be paying only one EMI for the personal loan rather than multiple smaller EMIs, so your chances of defaulting on a payment or missing any payment become negligible.
The Bottom Line:
- Taking out a personal loan lowers your credit utilization ratio, which is the second most important element that affects your credit score.
- Paying back the loan on time will not only help you improve your credit score, but will also help you build it over time?
- A personal loan will improve your credit mix, resulting in a higher credit score.
A personal loan will lower your credit score in the short run, but making on-time payments will restore it and help you develop credit. The important thing is to repay the loan on time. Before applying for a personal loan, you should use a personal loan calculator to find the best loan repayment terms for you.
Remember that if you pay late or default on the loan, your credit score will suffer. Also, keep in mind that a personal loan may lower your borrowing ability for other lines of credit.