Just like any form of credit, a personal loan affects your credit rating. Timely payment will see it improve while delinquent payment will see it reduce and lock you out of some important credit options. That is the fundamental principle of credit scoring. There are other ways that each type of loan will affect your credit score and the personal loan is no different. In this article we are going to see what each process of taking on a personal loan does to your credit score.

1. The Application Process:

A personal loan begins to affect your credit rating before you get it. The process of inquiry will have various effects on your credit score. A prequalification inquiry with the bank triggers a soft check on your credit worthiness. A soft inquiry does not affect your credit rating. However, when you formally apply for a personal loan, the bank will perform a hard inquiry with the credit bureau and this shaves off a few points off your credit score. A hard inquiry will typically remain on your credit report for two or more years. Making multiple hard inquiries essentially tell the credit bureau that you are desperate for a loan and that gets alarm bells ringing. For this reason, it is advisable to avoid applying for loans multiple times or with many banks. Only apply to a lender after a diligent prequalification check with them and you are sure of the amount you are eligible for.

2. The Repayment Period:

This is the most consequential period in which your personal loan affects your credit score. The FICO credit rating method, which is the most commonly used approach, checks your payment history to generate your credit score, with that metric accounting for 35% of your score. when you miss your monthly payment by a few days, it is unlikely that the credit bureau will be notified, therefore your credit rating is unlikely to suffer. However, anything over 30 days’ lateness will most likely reach your credit report and affect your score. Such a delay in remitting your payment could lower your rating by as much as 110 points, which will almost guarantee a drop in your credit worthiness grade. When you consistently make timely payment for your loan, your credit score will continue to rise. Additionally, the remaining loan amount has a bearing on your credit score. A larger balance on your loan keeps your credit score low but as you whittle it down towards complete repayment, your credit score is bound to rise. The debt-to-income ratio is an important metric in calculating your credit score, which means that the faster you are able to clear your loan, the faster your credit rating is likely to rise or recover.

3. How You Use Your Loan:

Although the bank has little interest in the way you choose to spend your loan once you have applied and qualified, there are certain activities that can have a direct effect on your credit score. Using the loan for a credit consolidation for example should help your credit rise. First, if you have delinquent debt, the consolidation will be reported to the bureau as a good repayment and you should be awarded a few points for that. Going forward, considering you choose a favorable personal loan, you will have lower interest rates and lower monthly payments which should enable you to make your payments on time. With time, this will grow your credit score consistently.

4. Adding a Personal Loan to Your Extant Credit:

Although many people would expect the opposite to be true, holding different types of loans helps to increase your credit score. This metric, known as “credit mix” contributes 10% of your FICO score and is dependent on the variety of loans that you have. While the credit mix by itself will not save your credit score if you are not a disciplined borrower, adding a personal loan to your existing loans facilities can accelerate the growth of your score as long as you keep up the payments on all of them. If for example you have a home loan and credit cards, it would be better to take a personal loan than an extra credit card.

Resources:

1. https://www.nerdwallet.com/blog/loans/personal-loan-affect-credit-score/
2. https://www.thebalance.com/loans-and-credit-score-960031
3. https://www.thebalance.com/do-loans-affect-credit-315567
4. https://www.experian.com/blogs/ask-experian/how-does-a-personal-loan-impact-your-credit/