A credit score is primarily based on how well you have repaid your previous loans, whether you have defaulted or pre-closed any loan, what types of loans you have taken and is a majority of your income going in repaying loans. Let’s explore this further.
How can a personal loan have a positive effect on your credit score?
A personal loan is a credit facility. There are several ways in which a personal loan could impact your score:
- Paying your EMI on time - If you keep a good record of paying your EMIs on or before the due date, never incurring a late payment fee or not defaulting on the loan, this can help your credit score. Banks will report your repayment behavior to the credit bureaus. By paying everything on time, you will be recognized as a trustworthy customer.
- Consolidating debt - If you use a personal loan to consolidate your debt, you could benefit in many ways. You can close other lines of credit, thereby reducing the risk of missing payments. Now you can be at ease knowing you have only one EMI to pay.
- Diversifying your credit portfolio - Your credit score takes into account the different type of debt you have. For example, if you have a home loan (secured debt), credit card (revolving debt) and a personal loan (unsecured debt), it works well for your credit score. You may be wondering how having more debt is good for your score. Actually, you should not have debt where the total EMIs payable is more than 30% of your monthly salary. But if you have a different kind of credit lines, the credit bureaus recognize it as a good thing.
How can a personal loan have a negative effect on your credit score?
- Missed payments - If you miss paying your EMIs on time, you might be charged a penalty fee. However, above that, the bank will report the incident to the credit bureaus. This can bring down your credit score. As a customer, you will reflect as one who is risky or not creditworthy.
- Foreclosing the loan - You would think that closing your loan ahead of time would be a good thing? But banks don’t see it that way. To them, you have gone against the loan agreement and they are now at a loss of interest that they were supposed to earn from you. So, before you pre-close a loan, you should weigh out the pros and cons. It could cause your credit score to dip and hamper your chances of getting an approval on a future loan.
- Increased debt-to-income ratio - If you take on a personal loan while you already have other lines of credit, it could mean you will be paying more out of your salary toward debt repayment. For example, if you are earning Rs.60,000, and out of that, you are already paying Rs.20,000 EMI. This means 1/3rd of your salary is going in EMI. If you decide to take another loan and pay Rs.15,000 EMI, you will be left with only Rs.25,000 per month, which means you are keeping only less than 50% of your salary. So, this means, your debt-to-income ratio has exceeded 50%. This ratio should ideally be at 30%. It is a critical part of your overall credit health.
These are the important factors that affect your credit score when it comes to personal loans. It is advisable to do thorough research before you take any loan or line of credit. Always remember, pay your credit card bills and loan EMIs on time and your credit score should be healthy always!