How a Personal Loan Affects Your Credit Score
Like other types of financing, taking out a personal loan affects your credit score in a good or bad way depending on how you use it. To manage this financial responsibility more efficiently, it is wise to get enough information about its benefits and risks before applying for one.
Who Needs a Personal Loan?
A personal loan is a form of credit for personal expenses like buying furniture or travelling abroad. Unlike other types of financing that are designed for a specific purpose, like a business loan or a home loan, a personal loan can be spent on any expenses you desire. These include travel, home repair and improvement, startup ventures, emergency medical bills and hospitalisation or even to consolidate several loans and credit lines into one single account.
Your biggest sources of personal loans are the fintechs and online lenders although you can also get one from credit unions and banks. Banks seldom provide small-scale personal loans because they tend to focus on big loans with big returns.
Your chances of approval will depend on your credit score and financial capacity to repay the loan. The latter can be proven by your bank statements, income tax return and other proof of income. Your credit and financial standing will also affect the terms of your loan, including its interest rate and length of repayment.
Features of a Personal Loan
Most personal loans are unsecured, which means no collateral backs up the loan, although there are also lenders who offer secured personal financing. An unsecured personal loan has a higher interest rate charged to compensate the lender’s high risk of lending you money without any assurance that they can get their money back.
The amount you can borrow on an unsecured personal loan is also smaller ($1,000 and $50,000) compared to a secured one (up to $80,000 or higher). Sometimes, the lender can approve your loan application but may not grant you the amount you requested for, depending on the result of your creditworthiness assessment. A secured personal loan gives you better chances of being approved for the loan amount you need.
Personal loans also have a relatively shorter term of 1 to 5 years compared to other types of financing. The frequency of repayment is generally monthly, but you can negotiate with your lender if want your payments to be weekly or fortnightly.
Meanwhile, the interest rates of personal loans remain relatively high despite falls in the cash rate (now at a record low of 1 %). The current typical rate on unsecured variable-rate personal loans is 14.4 %.
How Credit Score Influences a Personal Loan
When you apply for a personal loan, the lender checks your credit score along with your credit report to assess your creditworthiness.
The credit report is a detailed summary of your personal credit history while a credit score is a three-digit numeric summary of your credit history. These records are compiled and regularly updated by credit reporting agencies, like Equifax and Experian. While available to you for free, lenders pay to access this information.
Good Score vs Bad Score
Credit scores typically range from the lowest 300 to the highest 850. Your credit score is assigned to you by the credit reporting agencies based on your credit history. Each credit reporting bureau uses its own scoring model, which results in the slight variation of your credit score.
The most popular credit scoring model used, however, is the FICO 8 score. This scoring model classifies credit scores into the following ranges:
300 to 559 – Poor
580 to 669 – Fair
670 to 739 – Good
740 to 799 – Very Good
780 to 850 – Excellent
A high credit score indicates good management of previous debts. It also suggests that you’re likely to practice the same smart attitude towards your future debts. As a result, you will be greatly favoured by lenders. The higher your credit score, the more likely you get approved for a personal loan. You are also likely to get loans at low interest rates and favourable loan terms because of your high creditworthiness.
How a Personal Loan Affects Credit Score
It is not only the credit score that affects the personal loan. Taking out a personal loan affects your credit score in a good or bad way, just like getting any other loans.
From the moment you inquire for this type of financing from several lenders, your credit score is already affected. When a prospective lender pulls out your credit report before deciding on your loan application, a “hard inquiry” gets added on your report and affects your credit score.
Too many hard inquiries lower down your credit score as it indicates that you have been applying for multiple new credits in a short period of time, which suggests financial stress. It also signals repayment trouble. Statistics have shown that borrowers with more than six inquiries on their credit reports are eight times more likely to declare bankruptcy than those without hard inquiries.
The negative impact of hard inquiries, however, differs for each borrower based on their unique credit histories. If you have a long and established credit history, the effect is minimal, sometimes slightly felt. However, losing five points off your credit score is significant if you only have a few credit accounts.
Rising Up or Falling Down?
How you handle your personal loan repayment also has a significant impact on your credit score in the future.
Your payment history impacts your credit score the most, making up to 35% of the total credit score. As you make on-time monthly repayments on your personal loan, your credit score significantly improves. The same thing also happens if you pay off your debt complete at the end of its term. This allows you to secure loans more easily and affordably in the future.
If you’re always late on your repayments or stop completing the repayment altogether, your credit score will plummet. Sometimes, it can fall down to a depth that will likely take you a long time to recover from. If your personal loan is secured, your collateral may also be repossessed.
Building Your Credit Score
Effectively managing your personal loan helps build your credit score if you’re just starting in the credit world. If you’ve managed to secure a bad credit personal loan, responsible repayments will also help fix your score.
This is why it is crucial to pay your dues on time and avoid late payments. Generally, with timely repayments, you can see and improvement in your credit score in 3 to 6 months. This will help you secure better and more affordable loans in the future.
To better manage your repayments, get an estimate of how much you can afford for a personal loan using a personal loan repayment calculator. It is also smart to compare rates before settling down with one. Before starting the repayments, incorporate your loan obligation into your budget to allocate funds effectively.
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