A personal loan is a very popular type of loan due to its variety of uses and relatively easy availability. It’s a great option for financing unforeseen financial needs (or emergencies), given that it doesn’t require any collateral or collateral and the approval process is easier compared to other loans. Given its popularity, most lenders have this product in their portfolio.
While it’s common knowledge that you need a good credit rating to get a personal loan, the reverse is also true. A personal loan, if used wisely, can help improve your credit score. It is important to understand a bit about credit score and personal loan before understanding the relationship between the two.
What is a credit score?
A credit score is a value assigned to a borrower based on their credit history. This is a numerical value between 300 and 900, which determines their creditworthiness. The closer this number is to 900, the better and vice versa. In India, there are four credit bureaus which are authorized by the regulator to issue a credit score.
- Transunion CIBIL (Credit Bureau India Limited)
- High CRIF rating
Credit Score Interpretation
Many lenders consider the CIBIL score to check the creditworthiness of potential customers. The different levels of the CIBIL score and their interpretations are:
- Above 750 – Excellent: Indicates responsible credit behavior. Lenders prefer these customers and offer them the best interest rates because they have a lower 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: Indicates few failures or late payments in the past. A lender will most likely grant the loan, but at a slightly higher rate and possibly after more paperwork. The borrower may not cede too much bargaining power with the lender.
- 550 – 649 – Average: Lenders might be reluctant to lend to these borrowers because the score indicates risky financial behavior. However, people in this bracket can improve their credit score and move up to the next bracket, provided they follow good financial practices.
- Less than 550 – Poor: This is considered a bad credit score. People in this bracket could most likely have defaulted on their payment obligations in the past or have unpaid dues. They have almost no chance of getting a loan as lenders consider this to be a high risk category.
A borrower with this score is likely to be financially unstable, have defaulted on payment obligations in the past, or incurred significant debt, etc.
Factors that negatively affect credit score
Although these are broad interpretations of credit scores, here are some of the factors that negatively affect your credit rating –
- Delay in Reimbursing Credit Card Charges
- Absence of repayment of loans
- Apply for or have multiple credit cards at the same time
- Filing for bankruptcy
- Frequent use of the credit card up to the maximum authorized credit limit
- Closing a credit card that has an outstanding balance
Armed with this knowledge, you can adopt prudent credit practices and responsible financial behavior, in order to always maintain a good credit score. With a good credit rating, lenders will be more than happy to offer personal loans and many other loan products for your needs. Although the personal loan is an extremely popular type of loan, it makes sense to understand this product a little more in order to make an informed decision.
What is a personal loan and what is it used for?
As the name suggests, a personal loan is used to meet financial needs of a personal nature. A personal loan does not require any collateral or collateral and is disbursed to a person based on their income level, credit rating, repayment capacity, work history, etc. Given the relative ease of application and speed of disbursement, this is a very popular loan. instrument.
Some of the uses of a personal loan are:
- Buy gadgets or home appliances
- Take a break
- Medical or other emergencies
- Financing higher education
- home renovation
- Consolidation of existing loans
Some people also use a personal loan to fill funding gaps in their business or professional practice, although there is a separate category of loans for this purpose, called business loan and business loan respectively.
Most personal loans have basic eligibility criteria regarding age, job tenure, monthly income, documentation, etc. Also, there is relative flexibility for the repayment tenure ranging from one year to five years.
Benefits of a personal loan
A personal loan has several advantages over other types of loans. These are:
- Lower interest rate than a credit card loan – A credit card loan can be very expensive ranging from 18% to 36% per year (indicative rates), while a personal loan varies from 10.50% to 15% per year (indicative rates).
- Flexibility of use – There are many purposes for which a personal loan can be used, and the lender does not ask the borrower what the end use is.
- No collateral requirement – The personal loan is an unsecured loan offer and does not require you to pledge any assets.
- Minimum documentation – The paperwork for a personal loan is quite simple, quick and done mostly online by most lenders, requiring no face-to-face interaction.
- Fast disbursement compared to other loans – Depending on your credit score, income level and document readiness, a personal loan can be disbursed within hours.
Simply availing a personal loan does not affect your credit score positively or negatively. How a personal loan is used can have a lot of effect on the same. Using a personal loan the right way can do wonders for your credit score. However, the reverse is also true.
A badly managed personal loan can cause your credit score to plummet in a short time. Below are some ways to improve your credit rating with a personal loan and the habits that can cause it to deteriorate.
How to improve your credit score with a personal loan
If you have too many loans running simultaneously at different interest rates, you can consolidate them into one personal loan. If the loan is at an interest rate below the average of your current interest rates, this reduces your monthly interest expense. This makes it easier to repay, given the reduced interest charge, and improves your long-term credit score.
- Build a credit history
A longer credit history shows you’ve been responsible for credit over time. This helps strengthen your credit profile and credit score. If you haven’t borrowed till date, you will have no credit history. Taking out a personal loan is a good starting point for building your credit history.
Repaying dues on time is a sign of good credit behavior. This shows financial discipline and ultimately improves credit rating. A clean repayment on an unsecured personal loan has an even stronger impact on one’s credit rating.
- Diversification of the credit mix
When calculating the credit score, the formula takes into account the overall credit composition of a borrower. If you lean too much towards one type of loan, it can affect your credit score. A healthy mix of secured and unsecured credit helps diversify the credit mix and improves credit rating. It’s like saying, “Don’t put all your eggs in one basket.”
- Reduce the charge on credit card limits
If you continue to borrow up to the maximum limit available on your credit card (called credit utilization), this reflects badly on your long-term credit score. Having a personal loan can ease your credit card limit, improving your credit score.
How a personal loan can negatively affect your credit score
- Too many difficult inquiries on the credit report
Each time you apply for a personal loan, potential lenders will issue a thorough investigation of your credit file, to find out your creditworthiness. While one or two inquiries may not have much of an impact on credit rating, too many inquiries can have a negative impact on it.
Therefore, do not rush to find out from too many lenders. Instead, do your homework in advance by learning about good lenders who offer a combination of benefits such as an attractive interest rate, moderate processing fees, low or no prepayment fees, long term favorable occupancy, a hassle-free process, minimal documentation, etc.
- Increase debt rather than consolidate
As mentioned earlier, a personal loan should be used to consolidate existing debt. It should replace higher cost debt with lower cost debt. If you’re already sitting on a pile of debt that you’re struggling to repay, that will be considered irresponsible financial behavior and lower your credit score.
- Not taking the personal loan from the right lender
As mentioned earlier, you need to do your homework just before choosing a lender. Getting a personal loan with a high interest rate, processing fees and charges only burdens you more. In such a case, if you miss or are late on any of your payments, it negatively affects your credit score.
It’s important to make sure you’re not just focusing on the interest rate when choosing a lender. Pay attention to the full range of fees, service levels, and the lender’s financial situation before moving forward.
A personal loan can improve or worsen your credit score depending on how you use it. Whatever type of loan you choose, the most important thing to remember is to have prudent financial habits. Here are some tips that will help you build a healthy credit score and stay stress-free.
- Borrow only what you can repay, don’t put too much pressure on your finances.
- Respect your EMIs with the utmost discipline and make sure you don’t miss or delay payments.
- Borrow only when you need it. Have a clear end use for the borrowed amount before borrowing.
- Decide how much to borrow before you apply for a loan and only borrow that amount.
- Do your research on lenders and all they have to offer and choose the combination that works best for you.
- Remember that your credit score reflects your creditworthiness and financial discipline. Take care of it like you would take care of your social status.