Personal loans are an excellent financial instrument to tide over a crisis or fund a big purchase. But applying for a loan affects your credit score adversely. Depending on how well you manage your repayment, your score may rise again. Still, exploring all the risks and benefits is essential before applying for a personal loan. In the end, the net impact of a personal loan should be positive on your credit score.
What is a Personal Loan?
Personal loans are consumer loans wherein the borrower is free to use the funds as they want. They are helpful financial instruments that anyone may need in an emergency. Some loans are designed to serve a specific purpose, such as home loans or vehicle loans. Sometimes, when people find themselves mired in credit card debt, they take a personal loan to pay that off. It is because personal loans have a lower interest rate compared to credit cards.
However, you must remember that personal loans are unsecured and don’t require any collateral. Therefore, the interest rates on personal loans will be higher than other financial instruments like auto loans or home loans.
How Does Applying for a Personal Loan Affect Your Credit Score?
As discussed above, getting a personal loan can impact your credit score negatively. Here are some reasons and instances that will help you understand how loans affect your credit score –
1. Shopping for a Personal Loan – When shopping for personal loans, your potential lenders may ask for a soft credit pull on your credit report. A soft inquiry does not affect your credit score. However, many lenders do not work with soft searches and will insist on placing a hard inquiry. A hard inquiry can impact your credit score adversely. As long as you are in the loan comparison process, stick to lenders who offer a soft credit pull. It will allow you to weigh your options without affecting your credit score.
2. Applying for a Personal Loan – Before submitting an application for a personal loan, check your credit score and do everything to boost your score. Lenders place a hard credit pull on your credit report, and that causes your credit score to drop. Do not apply to multiple lenders within a short time, as it may lead to a significant drop in your credit scores.
3. Repaying Your Personal Loan – Your credit score is deeply impacted by the pattern of repayment you follow. There are three essential aspects of your repayment pattern that can affect your credit score –
Time overdue – How long has it been since you missed a payment?Amount overdue – How much amount is pending to repay?
4. Frequency – How often do you miss a payment date or make late payments?
Debt Consolidation – Consolidating all your debts into one personal loan can help improve your credit score. Having only one loan to repay instead of many pending bills/loans improves your credit utilization ratio. This positive effect depends on how well you keep up with the repayment schedule and whether or not you take up more borrowing.
5. Build a Better Credit Mix – A diversified credit mix such as a mix of personal loan, credit card, and mortgage are suitable for your credit score. It shows lenders that you can handle different kinds of debt and reliable borrowers.
6. Reduce Your Credit Utilization Ratio – The credit utilization ratio refers to the amount of revolving credit you are using. If you use too many credit cards, you may not be able to keep this ratio under control. Instead, getting a personal loan is a great way to correct the credit utilization ratio.
You can avail of a personal loan to finance a wedding celebration, pay emergency hospital bills, or start a new business. They help you meet unexpected expenses or tide over a difficult time in business. However, suppose you wish to use personal loans to your advantage. In that case, it is essential to know how loans affect your credit score and boost your score beforehand. Carefully weigh the pros and cons of a financial instrument before applying for a loan.
Author Bio:
Tanya Singh works as a Content Marketer at LoanTube – a loan comparison marketplace where borrowers can connect with multiple lenders via a convenient and transparent application. She writes about topics related to personal finance and loans helping her readers in making smart decisions when they need to borrow. Yoga brings her inner peace and strength, and travelling brings her joy (besides her work of course).