Lending institutions give more importance to the credit score of the borrowers while approving a loan. These days, borrowers are also keeping a close eye on the credit score and want to improve it to increase their creditworthiness so as to get hassle-free credit. There are many ways of improving your credit score and there are also many myths about the same. Many believe that applying for a personal loan will affect their credit score negatively. This is not true but in fact, taking a personal loan and paying it on time can improve your credit score.
To better understand how a personal loan has an impact on the credit score it is important to know how the credit score works.
How does the credit score work?
In the UAE, the Al Etihad Credit Bureau (AECB) collects the credit data and information from banks and financial institutions to maintain correct data about the credit score. The credit score ranges between 300 to 900 and the credit score which is between 750 is preferred by the banks. You can check your credit score on the official website at https://aecb.gov.ae/. There are a few important factors that the board considers to calculate the credit score. Below are a few most important factors that banks consider while calculating the credit score which is presented in the descending order of importance.
- Credit history of the borrower
- The utilisation of credit limit
- Length of the credit history
- Credit Mix
- New Credit
1. Credit history of the borrower
The bank looks at the credit history of the borrower and then decides whether to issue a loan or not. If the borrower has taken loans before, successfully cleared it and obtained no objection certificate from the bank.
The credit score of the borrower will increase positively and becomes attractive in the eyes of the bank. Banks will be ready to issue loans to such borrowers.
Suppose if the borrower has not paid the loans on time and there are payment defaults then the banks will not approve the loan.
2. Utilisation of Credit limit
While calculating the credit score, credit limit utilization is also considered. If a credit card holder utilizes more than 30% of the credit limit then there will be a direct effect on the credit score.
The credit score keeps decreasing and will not be able to get any loans. The best practise is to use a credit card within the credit limit of 30%.
3. Length of credit history
The length of the credit history is also a major factor which can affect the credit score. Suppose if a borrower has taken a loan on a tenure for ten years. During the ten years period banks will hesitate to issue additional credit until the previous loans are fully paid and cleared.
However this may vary from case to case if the borrower has good ability to pay and has clear income sources then banks may issue additional credit irrespective of the length of borrowing period.
4. Credit Mix
Credit mix includes the credit that a borrower has got from the different sources such as credit cards, student loans, automobile loans, home loans, mortgage loans and others.
If payment is defaulted by any of the credit facilities then the borrower will not be able to get any additional form of credit. Banks and lending institutions analyse the credit mix of the borrower prior to issuing the loan.
5. New Credit
Opening a new credit card or rather applying for a new loan will also affect your existing credit score. If a borrower applies for a loan with different banks even that will have an effect on the credit score.
Banks will check the credit of the borrower with a hard inquiry; it’s also known as hard pull. They make a note of the review in credit reports and it will reduce the credit score. If the credit score reduces it becomes difficult to get personal loans from the bank.
Having understood how the credit score works let’s look into what is the impact of personal loan on the credit score.
Impact of Personal loan on Credit score
Since personal loan is an unsecured loan the interest rate is highly competitive and the funds can be used for any financial needs. The type of loans does not have any impact on the credit score as long as the borrower repays the personal loan on time.
If the personal loan is repaid on time then the credit score will improve positively. If the borrower fails to repay the loan then it will have a negative impact on the credit score.
As far as credit rating is concerned utilising a personal loan is better than using a credit card. There is no burden of credit limit utilisation on the personal loan and credit score improves on full payment of loan. Other factors like credit history length and credit mix also add positively to the credit score.
When a borrower applies for a new personal loan then the credit score falls by a very small number and this is only temporary it can be recovered over a period of time by repaying the loan. When the personal loan is regularly repaid the credit score numbers which are reduced will increase over a period of time.
- Getting an additional loan during the ongoing period of loan repayment becomes difficult.
- Temporarily the credit score will be lowered because you have a debt and that too it’s an unsecured debt.
- Repayment of personal loans on time will not only increase your credit score, you will also get additional offers from banks.
- Applying for a personal loan and repaying it in a timely manner improves the credit score of the borrowers. If it is not repaid it will have an adverse effect on the credit score.
Takeaway
The bottom line is that use the personal loan responsibly and repay it on time as it will help you in increasing your credit score. If credit score increases banks will provide additional loans to you on good rates, since you have a good credit payment history.
About the author
Vinay Kumar Goguru is a finance professional with more than 8 years of diverse experience as a researcher, instructor and Industry work experience with both public and private entities. Prior to MyMoneySouq, he spent 6 years in Berkadia, It's a commercial mortgage banking company. He has a "Doctoral Degree in Commerce" and two master's degrees with a specialization in Finance, one as Master of Commerce and other as Master of Business Administration. He has written several articles on personal finance, published by different International journals. He loves traveling, reading and writing is his passion. He has a dream of writing a book on his favorite finance topics.
