A personal loan is a very popular type of loan due to its versatility and relative ease of availability. It is a great option for financing unplanned financial needs (or emergencies) as it does not require collateral or security and the approval process is simpler compared to other loans. Due to its popularity, most lenders have this product in their portfolio.
While it is common knowledge that you need good credit to get a personal loan, the opposite is also true. A personal loan, if used wisely, can help you improve your credit score. It’s important to understand a little bit about credit scores and personal loans before understanding the relationship between the two.
What is a credit score?
A credit score is a value attributed to a borrower based on their credit history. It is a number between 300 and 900 that determines creditworthiness. The closer this number is to 900, the better it is and vice versa. There are four credit reporting agencies in India that are authorized by the regulator to issue a credit score.
- Transunion CIBIL (Credit Information Bureau India Limited)
- experiential
- CRIF High Mark
- Equifax
Interpretation of creditworthiness
Several lenders use the CIBIL score to determine the creditworthiness of potential customers. The different levels of the CIBIL score and their interpretations are:
- Over 750 – Excellent: Indicates responsible lending behavior. Lenders favor such customers and offer them the best interest rates because they have less risk of default. Borrowers can also negotiate with lenders for better rates as their bargaining power is high due to their high score.
- 650 – 749 – Good: Shows few payment defaults or delays in the past. A lender will most likely grant the loan, albeit at a slightly higher interest rate and possibly after more paperwork. The borrower must not give up too much bargaining power to the lender.
- 550 – 649 – Average: Lenders may be reluctant to extend credit to such borrowers as the score indicates risky financial behavior. However, people in this class can improve their credit score and move up the class provided they follow good financial practices.
- Less than 550 – Bad: This is considered bad credit. People in this group could most likely have a history of late payments or unpaid fees. You have almost no chance of getting a loan as lenders consider this a high risk category.
A borrower with this score is likely to be financially unstable, have a history of defaulting on payments, or have large amounts of debt, and so on.
Factors that adversely affect creditworthiness
While these are broad interpretations of credit scores, below are some of the factors that negatively impact your credit score –
- Delay in paying back credit card fees
- Missed repayment of loan fees
- Apply for or hold multiple credit cards at the same time
- declare bankruptcy
- Frequent use of the credit card up to the maximum allowed credit limit
- Closing a credit card with an outstanding balance
Armed with this knowledge, you can employ prudent lending practices and responsible financial behavior to ensure you always maintain a good credit history. With a good credit history, lenders are happy to offer personal loans and numerous other lending products to meet your needs. While personal loans are an extremely popular type of loan, it’s worth understanding this product a little better so you can make an informed decision.
What is a personal loan and what is it for?
As the name suggests, a personal loan is designed to meet personal financial needs. A personal loan requires no collateral or collateral and is disbursed to an individual based on their income level, credit history, ability to repay, employment history, etc. It is a very popular lending instrument given the relative ease of use and disbursement speed.
Some of the uses of a personal loan are:
- Buy gadgets or household appliances
- weddings
- take vacation
- Medical or other emergencies
- fund higher education
- home renovation
- Consolidation of existing loans
Some individuals also use a personal loan to bridge funding gaps in their business or professional practice, although there is a separate category of loans designed for this purpose, known as business loans and professional loans respectively.
Most personal loans have basic eligibility criteria related to age, employment year, monthly income, documentation, etc. There is also relative flexibility for the repayment term, from one year to five years.
Benefits of a personal loan
A personal loan has some advantages over other types of credit. These are:
- Low interest rate compared to credit card loan – A credit card loan can be very expensive, ranging from 18% to 36% per year (guide rate), while a personal loan ranges from 10.50% to 15% per year (guide rate).
- flexibility of use – There are numerous reasons a personal loan can be availed and the lender does not ask the borrower about the ultimate use of the same.
- No collateral requirement – Personal loan is an unsecured loan offering and does not require pledging of assets.
- Minimal documentation – The paperwork for a personal loan is fairly simple, quick and mostly done online by most lenders, so no in-person interaction is required.
- Fast payout compared to other loans – Depending on your credit rating, your income level and the maturity of the documents, a personal loan can be paid out in a few hours.
Simply taking out a personal loan has neither a positive nor a negative effect on your creditworthiness. How a personal loan is used can have a big impact. Proper use of a personal loan can do wonders for your credit score. However, the reverse is also true.
A mismanaged personal loan can falter your credit score in a short period of time. Below are some ways you can use a personal loan to improve your credit score and the habits that can cause it to worsen.
How to improve your credit score with a personal loan
If you have too many loans that are going at different interest rates at the same time, you can combine them into a single personal loan. If the loan bears interest at a lower rate than the average of your current interest rates, this will reduce your monthly interest outflow. In view of the lower interest burden, this makes repayment easier and improves your creditworthiness in the long term.
- Building a credit history
A longer credit history shows that you have used credit responsibly over time. This helps strengthen your credit profile and creditworthiness. If you haven’t borrowed anything to date, you have no credit history. Getting a personal loan is a good place to start building your credit history.
Timely repayment of fees is a sign of good credit history. This shows financial discipline and ultimately improves creditworthiness. A clean repayment on an unsecured personal loan has an even bigger impact on your credit score.
- Diversification of the credit mix
When calculating creditworthiness, the formula takes into account a borrower’s overall credit mix. Choosing too much on one type of loan can affect your credit score. A healthy mix of secured and unsecured loans helps diversify the loan mix and improve creditworthiness. It’s like saying “don’t put all your eggs in one basket”.
- Reduce the burden of credit card limits
Borrowing up to the maximum limit available on your credit card (known as credit utilization) will have a bad impact on your creditworthiness in the long run. A personal loan can relieve your credit card limit somewhat and thereby improve your creditworthiness.
How a personal loan can negatively affect your credit score
- Too many hard requests for credit reports
Whenever you apply for a personal loan, potential lenders will make a rigorous request for your credit report to determine your creditworthiness. While one or two inquiries won’t greatly affect a credit score, too many inquiries can negatively impact it.
Therefore, do not rush to check with too many lenders. Better do your homework beforehand by researching good lenders that offer a mix of benefits like attractive interest rate, moderate processing fees, low or no upfront fees, cheap term, hassle-free process, minimal documentation, and so on.
- Build up debt instead of consolidating it
As previously mentioned, a personal loan should be used to consolidate existing debt. It should replace a higher cost debt with a lower cost debt. If you are already in debt that is difficult to pay back, it will be seen as irresponsible financial behavior and your credit rating will decline.
- Not taking the personal loan from the right lender
As mentioned before, you need to do your homework before choosing a lender. Taking out a personal loan with high interest rates, processing fees, and fees will only burden you further. In such a case, if you miss or delay one of your payments, it will negatively affect your credit score.
It’s important to make sure that you don’t just focus on the interest rate when choosing a lender. Be aware of the lender’s full range of fees, service levels, and financial standing before proceeding.
bottom line
A personal loan can improve or worsen your creditworthiness depending on the purpose. Whatever type of loan you choose, the most important thing to remember is to have prudent financial habits. Below are some tips to help you build a healthy credit score and stay stress-free.
- Borrow only what you can pay back, don’t put undue pressure on your finances.
- Stick to your EMIs with the utmost discipline and make sure you don’t miss or delay any payments.
- Borrow only when you need it. Before borrowing, make sure you have a clear purpose for the borrowed amount.
- Determine the amount of borrowing before applying for a loan and only borrow so much.
- Find out about lenders and what they have to offer, and choose a combination that works best for you.
- Remember that your credit score is a reflection of your creditworthiness and financial discipline. Take care of it just as you would take care of your social position.
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