Personal loans are useful when you have no other means of getting money. However, they also add a debt burden that stands on record in your credit file.
The long and short of it is that personal loans have both a positive and negative impact on your credit scores. As much as it shows your creditworthiness if you get approved for one, it also clearly indicates that your debt has increased when you have one.
And because they are usually unsecured, the interest rates charged on personal loans are higher than those charged on other types of loans like mortgages. Personal loans are therefore double-edged swords, as we’ll explain to you in our article below, and should only be taken when absolutely necessary.
How Taking A Personal Loan Affects Your Credit Score
Good – Personal Loans Replace Your Credit Cards
Personal loans generally have lower interest rates than credit cards.
Instead of using credit cards, consider replacing them with a personal loan. Personal loans offer a fixed repayment period, which gives you time to pay, meaning that you’re more likely to stick to the payment plan.
When you take personal loans that you’re able to repay comfortably, it adds to your credit history. This payment points to your creditworthiness, which pushes up your credit limit, allowing you to access more funding for high-cost projects in future.
A personal loan further adds to your credit mix, one of the parameters used by lenders to determine how creditworthy you are.
Good – They’re An Excellent Way To Consolidate Debt
An excellent way to manage multiple credit card balances is through debt consolidation.
This approach uses low-interest rate loans to repay high-interest rate credit card balances, making personal loans one of the best options to settle credit card debt, and move you into the category of the population who service ‘good’ debt.
Finder.com.au reports that a majority of Australia’s personal debt is classified as ‘good debt.’ 92.8% of personal debt is good debt, while bad debt stands at a paltry 8.2%.
56.3% of the personal loans are channelled towards home loans, while another 36.5% is invested. Perhaps personal loans are one of the mains reasons why Australia’s debt-income ratio is so high, currently at 88%.
Good – They’re A Good Alternative To Credit Cards During Emergencies
No one expects for emergencies, but it is always prudent to plan for them. You’re never sure when you’ll fall sick, or have an accident, or need to replace an expensive household appliance.
Despite having insurance cover, an urgent medical case may arise, requiring immediate expenses that reach beyond your protection.
For many people, a credit card is the first facility they reach for when in need of emergency credit. However, a personal loan can be an excellent way to borrow the money still while enhancing your credit score.
Besides, these loans save you from the exorbitant interest rates often charged on most credit cards.
Remember, savings trump both credit cards and personal loans, and while you may still opt for a loan, cultivate savings to avoid borrowing in future.
Good – They Help You To Establish A Solid Repayment History
Your credit repayment history is vital to having a good credit score and maintaining a good credit report.
Personal loans work to build a positive repayment history, but you must keep to the repayment plan. When you repay your loan instalments on time, it helps lenders to assess your financial behaviour, and be more open to lending to you in future.
Good – They Lower Your Credit Utilization Ratio
A lower credit utilization ratio influences your scores positively and vice versa.
A personal loan can help you retain a low credit utilization ratio because this ratio applies only to short-term revolving credits, something of which lenders take note.
A personal loan is a long-term instalment-based credit facility, so it would not affect this ratio. As such, you can use it to clear revolving credit facilities and improve your credit scores.
Bad – Fail To Pay Your Loan And Watch Your Credit Score Drop
The worst thing you can do after taking a loan is to fail to pay it altogether.
Failure to pay hurts your credit scores, as it indicates harmful or reckless financial behaviour.
Pay loan instalments on time to avoid falling into this trap.
You may also consider having a backup savings account or taking out loan repayment insurance so that in the event you can’t pay; the loan will still be serviced, thus saving your credit reputation with the lenders.
Bad – Personal Loans Increase your Credit Hard Inquiries
Taking personal loans increases your hard inquiries.
A hard inquiry is a credit check by your lenders, and each query hurts your credit scores. Since a hard inquiry remains on your credit report for several months, having a large number of them lowers your score.
Avoid seeking personal loans from many lenders, and especially when you don’t need it. If you’ve got to take a loan, you should plan for the consolidation of your applications to avoid negative impacts on your credit report.
Personal loans are a great way to access credit and building up your repayment history.
On the other hand, unplanned, multiple personal loans, or loans that don’t generate revenue, i.e. ‘good debt’ can hamper your financial stability and freedom, as well as pull down your credit score.
Before taking personal loans, consider all these factors. Study the merits of taking a personal loan against other types of loans so you can get the best loan facility for you.