In Which Other Circumstances Should A Personal Loan Be Considered
A personal loan is a common and effective way to consolidate high interest debt, such as credit card debt. Other situations where a personal loan can be helpful are to finance a major expense such as a home remodel or a wedding, or to resolve a high-cost emergency.
As with any kind of debt, be mindful of how much you take on and what itâs for. If you can, save up in advance for large expenses. Work to build up an emergency fund so you donât have to rely on credit to cover unexpected expenses. And donât borrow money you donât need.
Buy-now-pay-later loans allow you to finance a big purchase over time using a series of installment payments. BNPL loans are becoming more popular in Canada and are available to use with certain retailers. The exact loans will vary between retailers.
The main risks involved with using a BNPL loan include borrowing more than you can pay back, paying a high interest rate, and hurting your credit score if you miss your installment plan payments. If you have a good repayment plan in place, then using a BNPL payment option like Affirm PayBright can be useful in breaking up your purchase into more manageable payments.
How A Personal Loan Can Help Your Credit
Depending on how you use them, personal loans can help to improve your credit score in several ways.
- Contributing to a better credit mix: Having a variety of different types of credit helps to boost your credit score. A personal loan is an installment loan . If most of your credit is revolving credit, such as credit cards, a personal loan can enhance your credit mix.
- Helping you build a payment history: Making your personal loan payments on time helps to establish a positive payment history, which can increase your credit score.
- Reducing your credit utilization ratio: Because it’s an installment loan, a personal loan doesn’t factor into your , which measures how much of your available revolving credit you’re using. Using a personal loan to pay off revolving credit, such as credit card debt, can help you improve your credit scores by replacing revolving debt with an installment loan .
Do Personal Loans Affect Your Credit Score
Lenders now lay major emphasis on the credit score of the borrowers before approving a loan application. As a result, a large number of people, especially young working professionals, now look for ways to improve their creditworthiness. While there are ways to improve the credit score, there are also many myths surrounding the whole topic.
For instance, many believe that taking a personal loan would negatively affect their credit score. This is untrue, and as a matter of fact, a personal loan can be used for improving the credit score. To understand the relationship between a personal loan and credit score, it is first essential to know how the credit score is calculated.
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New Credit And Personal Loan Application
New credit is the last most important factor for the credit bureaus. Every time you apply for a new loan, your credit score falls slightly. This is the reason why it is said that you should avoid applying for loans at multiple lenders within a short duration.
However, this fall is very small and only temporary and will not really affect your credit score or personal loan eligibilityin the long run. Once you start repaying the personal loan on time, this fall in the score gets eliminated, and you actually get the opportunity to improve the score.
How Much Does A Loan Affect Your Credit Score
In truth, the only people who can give you a precise answer here are the three credit bureaus that calculate credit scores: Experian, Equifax and TransUnion.
Sadly, they dont make their calculations public, so all we can do is speculate based on what they do publish. For example, they do generally make it clear that the most important factor in a credit score is managing money responsibly – that doesnt mean that you shouldnt borrow. For example, heres what Experian say:
A good credit score generally comes from a history of managing money responsibly. This doesnt mean you shouldnt borrow money though in fact, companies often like to see a track record of timely payments and sensible borrowing.
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What Makes Up A Credit Score
A credit score is calculated by your previous payment history , how much debt you currently have, the length of your credit history, credit utilization ratio, credit mix, and your account or enquiry activity. These factors determine how high or low your score is.
This is how having a personal loan can affect your credit score keeping up with payments, amount of existing debt, and making enquiries when applying. Applying for a loan is a hard enquiry. This means that the lender will review your credit report from to assess your application. This enquiry shows up on your credit report and affects your credit score for some time.
What Credit Score Is Ok To Get A Personal Loan
It shouldnt surprise you that a higher credit score opens up more loan opportunities for you. And if credit scores range between 300 and 850, everything that is higher than 670 is considered as OK. That means, if you have a credit score of 670 or higher, then your creditworthiness is approved.
What if your score is 669 and lower? Well, in most cases, you can still apply for a personal loan. But your options are more limited as far not many lenders offer bad credit loans.
Also, expect to have higher interest rates, a shorter period to pay off your loan, and other requirements. To encourage you, 69 percent of Americans had a good or better credit score in 2020.
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So What Is Meant By Credit Score
Simply put, a credit score is a way that a financial institution understands an individuals financial activities to gauge how much credit and at what rate can be lent to them. Its the street cred that you carry with banks. Your individual credit score will be viewed by all institutions alike and reads like an index of all your major financial activities.
Based on several factors, your credit score can increase or decrease. As long as you have a steady stream of income and diligently repay all loans, you will be rewarded with a healthy credit score.
Check out the factors that affect how a credit score is calculated –
1. Credit utilisation – It is a comparison between the amount of credit you’ve been lent and the value you’ve already used. The higher this figure, the better is their credit score.
2. Amount of debt – Another factor is the amount of debt an individual is in and the rate at which they repay it. Here, the credit score will increase with the increase in debt but only up to a point after which the credit score will be negatively affected.
Build A Strong Payment History
When you take out a personal loan, paying on time and in full is perhaps the most effective way to build a strong payment history and protect your credit score.
Think of your credit report as a CV or portfolio that you show to potential lenders. Ideally, you want it to show that you’re responsible, organised and you’ve had lots of experience. This might be less effective if it makes you look unreliable and forgetful.
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How Do Loan Applications Impact Your Credit
When you apply for a personal loan, lenders will assess your credit score and history to determine your credit risk or creditworthiness. To do this, theyll run a hard credit check. When they run this check, theyre looking for indicators of financial health, like low credit balances and a good debt-to-income ratio.
Whether or not youre in good financial standing, youll likely see a few points knocked off your credit score due to the hard check. However, you could see a drop of up to 10 points in some instances. While the latter is unlikely, applying for several personal loans at once could have an even greater impact.
The hard credit check is also referred to as a hard credit inquiry or hard pull. Hard credit inquiries remain on your credit report for up to two years. However, the impact will start dwindling within a few months and wont impact your credit score after 12 months.
Too Many Hard Inquiries Can Lower Your Credit Score
Using credit wisely is the best way to make it work in your favor. You should only apply for a personal loan when you actually need one for something important, like covering a large expense or consolidating credit card debt.
A hard inquiry happens when a lender accesses your credit report after you apply for a loan. Hard inquiries can remain on your credit report for up to two years. Too many of these inquiries can cause your credit score to go down because it indicates that you might be acquiring new debt. If you apply for many loans including personal loans in a short period of time, lenders may see that as a signal youre having financial trouble and are applying for loans to make ends meet.
Hard inquiries are different from soft inquiries, which dont affect your credit score at all. Soft credit checks can happen when you or a prospective employer view your credit report, or when you get a pre-approved offer from a lender.
Taking On Personal Loan Debt
If youre looking to take out a personal loan to build your credit, keep in mind how it affects your score.
When you take out a personal loan, youre increasing your credit mix, which makes up about 10% of your credit score and could give your credit score a boost. While increasing your credit mix is good, youre also increasing the amount of debt you owe, which can cause your score to drop.
Aside from the principal amount you borrow, youll also be responsible for interest and fees, if the lender you choose charges any. Even if you have every intention of repaying your personal loan, it still means youre increasing your debt burden. Even if you use your personal loan to take control of your existing debtlike paying off high-interest credit cardsyoull need to adjust your spending to include that monthly loan payment.
Taking out a personal loan to build your credit isnt a bad thingas long as you can afford it. If you cant afford it, you risk missing payments, which could lower your score. If youre making your monthly payments, make sure your lender is reporting your payment history to at least one of the three major credit bureaus.
Lenders arent required to report your payment history. If yours doesnt do so, you wont have anything to show for your hard work when you start paying it off.
Build A Positive Credit History
Lenders look at your credit report to find out whether you pay your bills on time or not, as this can indicate how likely you are to repay a new loan. If you take out a personal loan and make your monthly payments in full and on time each month, your credit report will show that and your credit score could improve. Payment history makes up 35% of your credit score.
What Is A Credit Score
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.
- Home renovation
- Consolidating existing loans
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.
Less Debt May Help You Qualify To Borrow More
Owing less on your student loans will improve your “debt-to-income ratio,” which is the share of your monthly income used to pay your existing debts.
Lenders look at this ratio when deciding how much to let you borrow. Some use something called the 28/36 rule, which specifies that no more than 28% of your monthly gross income go toward housing costs, and no more than 36% go toward total debts.
Forgiveness that reduces or even eliminates your monthly student loan payments could lower that ratio, “potentially helping you qualify for a larger mortgage, car loan or credit card limit,” Rossman said.
Don’t Expect A ‘huge’ Effect On Your Credit Score
Student loan forgiveness will probably have a modest impact on your credit score, said Ted Rossman, a senior industry analyst at CreditCards.com.
“I don’t think it will be huge,” Rossman said.
That’s because student loans are considered “installment loans,” meaning a loan you repay over a set period of time with regularly scheduled payments. Those aren’t weighted to heavily into your , which is how much you’re using of the credit available to you, he explained. Your utilization rate can account for up to 30% of your score.
Still, any score boost may help you get more favorable terms with other lenders.
Do Personal Loans Hurt Your Credit
Any debts you have can impact your credit, so taking out a personal loan might lead to a drop in your credit score over the short term. On the flip side, there could be ways for your personal loan to positively affect your credit score. Heres how a personal loan could negatively and positively impact your credit score:
Pros and Cons of Personal Loans When It Comes to Credit
| Pros |
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Could negatively impact your payment history if you miss payments |
How Does Your Credit Score Impact Your Application
Your is calculated using your financial history held by credit reporting bureaus, which is documented in your . Lenders use this score to assess how much risk there is involved in lending money to you. Your financial history consists of information such as:
- How many accounts you have had, both open and closed
- The types of accounts you have e.g. revolving or instalment credit
- Your credit limit on credit cards and personal loans.
- Your balance on any home loans
- How well you’ve managed your repayments in the past
- Whether you’ve previously defaulted on any accounts or have any other black marks such as bankruptcy and court actions.
If your credit score is lower, lenders consider you to be a higher risk. As a result, you might be denied a personal loan or only be eligible for one with a higher interest rate. On the other hand, if you have a good score, you are considered to be a better quality borrower. Lenders are generally more willing to offer a better interest rate or extend you credit if you have a higher credit score.
Applying For A Personal Loan
Formally applying for a personal loan triggers a hard credit check, which is a more thorough evaluation of your credit history. The inquiry usually knocks off less than five points from your FICO credit score. Overall, new credit applications account for about 10% of your credit scores.
A hard inquiry typically stays on your credit report for two years, but only affects your score the first year.
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Is It Better To Have A Personal Loan Or Credit Card Debt
Again, this is something that only the credit bureaus know for sure, and the answer is likely to depend on your circumstances, but a few things to consider if youre looking at personal loans vs credit cards:
- Cost – which form of credit is cheaper for you? This will be determined by the interest rate and how quickly you are able to pay off the loan, but a personal loan is often cheaper over the long term
- Flexibility – do you want to be able to dip in and out? If so, a credit card is a good option
- Loan amount – depending on your circumstances, theres a good chance you can borrow more through a personal loan than via a credit card.
Why Smart People Get Personal Loans
There are different purposes to get a personal loan. Getting a personal loan to pay for a vacation you couldnt otherwise afford is probably your main priority for a well-deserved relaxing time out. However, using a personal loan to consolidate several high interest debts into one lower-interest loan is one of the savvier ways to get a personal loan.
Paying off a credit card debt at a 20.00% APR with a personal loan that has an 8.00% APR can reduce your monthly payments, and put more money in your pocket each month after all your bills are paid. But the advantages go well beyond saving money on interest or freeing up some spending money.
Can You Avoid Hard Credit Pulls
To avoid hard credit pulls when shopping around for the best deal on a personal loan, you can get prequalified for a loan to protect your credit rating if its offered by the lenders youre considering.
Instead of submitting a formal application to the lender, youll answer a few questions about your identity, employment, income and housing expenses. The lender will use this information to generate a potential loan offer, and it wont impact your credit score since the process only involves a soft credit inquiry.
Loan prequalification, which is generally accessible online through the lenders website, is also beneficial because you can look at multiple lenders to find the best deals. You will know if you have strong approval odds with a lender and can view the estimated monthly payment amount, loan term and interest rate. You can use this information to create a shortlist of lenders that could work for you.
Still, you likely wont be able to avoid a hard credit check when applying for a personal loan. Even if you get prequalified, youll have to undergo a hard credit check if you decide to move forward with a loan application. However, the long-term investment of a personal loan could be worth it if you stay on top of your monthly payments.