How Do Personal Loans Affect Credit Score? – Forbes Advisor INDIA – Forbes

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Published: Apr 16, 2022, 11:00am
A personal loan is a very popular type of loan due to its varied usage and relatively easy availability. It is a great option for funding unplanned financial requirements (or emergencies), given that it does not require any collateral or security and the approval process is easier compared to other loans. Given its popularity, most lenders have this product in their portfolio.
While it is common knowledge that you require a good credit score to get a personal loan, the inverse is also true. A personal loan, if used wisely, can help you improve your credit score. It is important to understand a bit about credit score and personal loan before understanding the relation between the two. 
A credit score is a value attributed to a borrower based on their credit history. It is a numerical value between 300 and 900, which determines their credit worthiness. The closer this number is to 900, the better it is and vice versa. In India, there are four credit bureaus who are authorized by the regulator to issue a credit score.
Several lenders consider CIBIL score for ascertaining creditworthiness of potential customers. The various levels of CIBIL score and their interpretations are: 
A borrower with this score is likely to be financially unstable, has defaulted on payments in the past, or has assumed a large amount of debt and so on. 
While these are broad interpretations of credit scores, following are some of the factors that adversely affect your credit score –
Armed with this knowledge, you can adopt prudent credit practices and responsible financial behavior, so that you always maintain a good credit score. With a good credit score, lenders will be more than happy to offer Personal Loans and numerous other loan products for your requirements. While personal loan is an extremely popular loan type, it makes sense to understand this product a bit more so that you make an informed decision.
As the name suggests, a personal loan is used for fulfilling financial requirements that are personal in nature. A Personal Loan does not require any collateral or security and is disbursed to an individual based on their income level, credit score, repayment capacity, employment history, etc. Given the relative ease of application and speed of disbursal, it is a very popular loan instrument. 
Some of the usages of a personal loan are: 
Some people also use a personal loan for bridging funding gaps in their business or professional practice, though there is a separate category of loans catering to the purpose, called business loan and professional loan respectively. 
Most personal loans have basic eligibility criteria with respect to age, employment vintage, monthly income, documentation, etc. Also, there is relative flexibility for repayment tenure ranging from one year to five years. 
A personal loan has several advantages over other types of loans. These are: 
Just the action of availing a personal loan does not affect your credit score either positively or negatively. The way a personal loan is utilized can have a lot of effect on the same. Utilizing a personal loan in the right way can do wonders to your credit score. However, the reverse is also true. 
A poorly managed personal loan can make your credit score nosedive in a short duration. Below are some ways in which you can improve your credit score through a personal loan and the habits that can cause the same to deteriorate. 
If you have too many loans that are running simultaneously at different interest rates, you can consolidate them into a single Personal Loan. If the loan is at a lower interest rate than the average of your current interest rates, it reduces your monthly interest outgo. This makes it easier to repay, given the lower interest burden and improves your credit score in the longer run.
A longer credit history shows that you have been responsible with credit over time. This helps to strengthen your credit profile and credit score. If you have not borrowed till date, you won’t have any credit history. Taking out a Personal Loan is a good starting point for building your credit history. 
Timely repayment of dues is a sign of good credit behavior. This shows financial discipline and ultimately improves credit score. A clean repayment on an unsecured personal loan makes an even stronger impact on one’s credit score.
While calculating credit score, the formula considers the overall credit mix of a borrower. If you lean too much towards any 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 score. This is akin to saying, “Don’t put all your eggs in one basket”.
If you keep borrowing to the maximum limit available on your credit card (called credit utilization), it reflects poorly on your credit score in the longer run. Having a Personal Loan can take some pressure off your credit card limit, thereby improving credit score. 
Whenever you apply for a Personal Loan, prospective lenders will issue a hard inquiry on your credit report, to know your creditworthiness. While one or two inquiries won’t impact the credit score much, too many inquiries can have a negative impact on the same. 
Hence, do not rush to enquire with too many lenders. Rather do your homework beforehand by finding out about good lenders that offer a mix of benefits such as attractive interest rate, moderate processing fee, low or nil prepayment charges, favorable tenure, hassle-free process, minimum documentation and so on.
As mentioned earlier, 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 sitting on a pile of debt that you are finding difficult to repay, this will be seen as irresponsible financial behavior and will take your credit score lower. 
As mentioned earlier, you must do your homework right before choosing a lender. Going in for a personal loan that is high on interest rate, processing fees and charges only burdens you further. In such a case, if you miss out or get delayed on any of your payments, it adversely affects your credit score. 
It is important to ensure that you do not focus only on the interest rate while choosing a lender. Look out for the entire gamut of charges, service levels and financial standing of the lender before going ahead.
A personal loan can improve or worsen your credit score depending on how you use it. Whichever type of loan you opt for, the most important thing to remember is to have prudent financial habits. Following are some tips that help you build a healthy credit score and remain stress free.
Abhay Bhutada is the Managing Director of Poonawalla Fincorp Limited. He has over 15 years of diversified experience in retail and commercial lending. Abhay is a qualified chartered accountant.
Armaan is the India Lead Editor for Forbes Advisor. He has more than a decade’s experience working with media and publishing companies to help them build expert-led content and establish editorial teams. At Forbes Advisor, he is determined to help readers declutter complex financial jargons and do his bit for India’s financial literacy.

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