Can A Personal Loan Help You Improve Your Credit Score?

Rohan recently checked his credit score and to his dismay the number was nowhere near what he had hoped it would be. This threw a wrench in his future plans as he would need a much better credit score to get other long-term loans to finish his higher education and to buy a home.

Just like a number of other millennials, Rohan had a few credit cards that he used regularly to pay for everything from shopping sprees to monthly groceries. He was only paying off the minimum amount due to continue using his credit cards. This is when Rohan realized how necessary it was for him to find a way to consolidate his debts and pay-off all the high interest debt. His father came to his rescue and explained how he could resolve this situation by taking a personal loan and improving his credit score in the process.

Here are a few things Rohan learned from his father about how taking a  personal loan might help him improve his credit score. To help you benefit from this wisdom, Rohan has compiled a handy guide for your reference.
 

What is a Credit Score?

A credit score is a three-digit numerical value that indicates your creditworthiness, based on your credit history. The score ranges from 300 to 900, with 300 being the lowest and 900 being the best you can get. If your credit score for personal loan is higher, you can avail funds on favourable terms.
Credit score is calculated on numerous criteria, but the following factors affect it the most:
 

Credit payment history:

Your debt repayment history accounts for a significant portion of your overall credit score. In case you fail to make your equated monthly instalment (EMI) payments on time, even if your reasons are legitimate, it will appear on your credit report. This report informs the lender of your previous EMI payment diligence. Thus, even a single delayed EMI payment will have a negative impact on your profile and lower your credit score.
 
Credit payment history makes up around 35% of your personal loan credit score. 
 
Some important points related to credit payment history are as follows:
 

• In the event of late payment, the lender will enquire as to how recently you have settled the missed EMI. Delays of more than 90 days will lower your credit score more severely than those of less than 30 days.

 

• When gauging your payment history, credit bureaus also consider any foreclosures, loan-related lawsuits, bankruptcies, liens, etc. in your financial records.

 

Credit utilisation:

The percentage of the amount you utilise from the revolving credit line has an impact on your credit score. Assume you have two credit cards, each with a Rs 1 lakh limit. If you spend more than Rs 30,000 on each card, your credit score will suffer.
 

Credit mix - Types of loans availed:

You have probably seen various financial experts with a well-diversified portfolio, whether it's investment or debt. People with a credit mix are viewed as disciplined borrowers by credit bureaus. Assume you qualify for a Rs 5 lakh personal loan and you need Rs 4 lakhs to decorate your home and pay for your child's education. With the remaining funds, you intend to purchase your dream motorcycle. In this case, even if a personal loan meets your needs, you should still consider purchasing a bike with a two-wheeler loan. This will aid in the development of a credit mix. Credit mix accounts for around 10% of your overall score. 
 

Length of the credit period:

It is usually recommended to go for a longer repayment term, even if it means paying extra in interest. If you do this and pay all your bills on time within the loan’s tenure, the lender will have enough credit history to assess your repayment potential. The length of your credit period accounts for around 15% of your credit score. This credit period length is calculated based on the older and newer loan account tenure. 
 

New Credit:

New credits are subject to hard enquiries. When you apply for a new loan, information such as how many loans you have applied for recently and what is the time gap between each new account is recorded on your credit report. It happens because every time you submit an application for a new loan, your lender will conduct a thorough credit check on your profile. 
 
A soft enquiry is when the lender conducts a credit check to determine your eligibility for a pre-approved loan. Soft enquiries do not have an impact on your credit worthiness. 
 
Remember that hard enquiries account for around 10% of your overall credit score.
 
For financial institutions, credit score acts as a measure to evaluate potential risks involved in lending money to customers. It also aids in fixing the terms and interest rate of the loan.

What's not included in your credit score? 

Several factors do affect your loan approval but are not vital for credit bureaus in determining your credit score. A few of these are listed below. 
 

• Your annual income
• Occupation type
• Employer's reputation
• Job switch history
• Your business history
• Marital status 

 

What is a Personal Loan?

A personal loan is a type of unsecured loan availed to meet your current financial requirements. Unlike auto loan and home loan, which are earmarked for specific purposes, a personal loan has no such restrictions on end-usage.

The borrower enjoys the freedom to choose how they want to spend the funds from a personal loan. A personal loan is also relatively easier to get as compared to other loans. Applications for personal loans are processed based on your income stability, employment status and repayment capacity. The average loan duration ranges from 12 months to 60 months.

Since personal loans are unsecured, the loans are approved with stricter terms and high interest rate compared to secured loans. However, despite a few disadvantages, personal loans offer multiple benefits to borrowers. They are a great option for improving your credit score, which extends a positive effect on future loan applications.
 

How can a personal loan improve your credit score?

Most personal loans are unsecured and financial institutions rely less on credit score while approving a personal loan, it influences your credit score in many ways. Here are a few ways how personal loans help in strengthening your credit portfolio.
 

• Contributes to a Better Credit Mix

  Having a personal loan adds to a better credit mix to your loan portfolio and boosts your credit score. The strategy is useful when you are planning to take a bigger loan amount or have a limited credit history.
   
  When you manage all your credit accounts efficiently, it gets added to the credit report and is positively reflected in the score.
   

• Reduces Credit Utilisation Ratio

  The credit utilisation ratio shows your current usage of revolving credit compared to the total limit of revolving credit available to you. A high credit utilisation ratio can cause a significant drop in your credit score, as it indicates increased dependence on credit.
  
  Since a personal loan is not a part of revolving credit and is paid back in instalments at regular intervals; it does not affect your credit utilisation ratio. Utilising a personal loan to pay off revolving credit like credit card bills helps you improve your credit score.
  Apart from replacing revolving debt, it also prevents piling up of other debts in the form of interest.
   

• Helps Build a Favourable Payment History

  In the credit score calculation, credit payment history carries more weight as compared to other factors. Having a flawless credit payment history gives greater confidence to financial institutions to lend you money.
  
  Getting a personal loan and paying it off within the stipulated time frame helps you build a favourable credit history. The longer the credit history, the better your credit report will be, as it is a testimony of responsible credit behaviour.

 

• Helps Consolidate Debts

  With a personal loan, you can clear your older debts and restart paying-off the debt with new and better terms. This will get added to your credit history as a positive payment case and will help you boost your credit score.
   

• Useful to Pay-off High-Interest Debt

  It is always wise to pay-off all your high-interest debt first, as it helps to lower your total interest outgo. With a personal loan, you can pay-off high-interest debt like credit card debt in a single payment, and start repaying in affordable EMIs.
  The tenure of personal loan is spread over a period of 1- 5 years, and you can select the tenure that suits you.
   

How to increase credit score in India?

 

• Avoid using credit cards for extravagant spending. Keep the card for unexpected expenses, such as medical emergencies, grocery, and utility payments (if you have exhausted your monthly salary before the end of the month).
   

• In case avoiding the use of credit cards is not possible and you make most of your monthly purchases using the same, it is better to increase the credit card limit. 

 

• Timely review your credit report for any errors. If you find any discrepancies, get them fixed right away by contacting your existing lender or the credit bureau. 

 

• Take a credit builder loan such as a personal loan, consumer durable loan, etc. for an amount that you would be able to comfortably repay.

 

Conclusion

As per his father’s advice, Rohan has already started looking for the best personal loans to meet his requirements and he hopes his father’s insight helps you improve your credit score too. As he said, a low credit score can hamper your financial standing and must be addressed immediately. While it is not possible to improve your credit score overnight, taking a personal loan is a step in the right direction. Rebuilding your credit history should be your priority and with personal loans, you can improve your credit rating more effectively.
 

Disclaimer: This post was first published on 15th November 2021 and has been updated for the latest information, freshness, and accuracy.