Enhancing Credit Scores through Personal Loans: Myth or Reality?

Does taking out a personal loan hurt your credit score? Or will a personal loan quickly fix your credit score?

With credit score being one of the most crucial factors in the personal loan application process, there are naturally many myths and doubts surrounding them. Let’s help you uncover the most common credit score myths and the truth behind them. We will also take a look at some ways to maximize the benefits of your personal loan for credit score enhancement.

What is a Credit Score? Why is it important?

A credit score, also commonly known as a CIBIL (Credit Information Bureau India Ltd.) score is a 3-digit value that is a summary of your complete credit history. It is derived from factors like your payment history on credit cards or loans, outstanding debt if any, length of credit history, and so on. In India, credit scores typically range from 300 to 900. A score of 700 to 749 is usually considered a “good credit score” while scores of 750 and above are considered “excellent”.

When you apply for a personal loan or credit card, lenders will turn to credit scores to assess how likely you are to repay the loan on time. Borrowers with higher scores are often viewed as low-risk and can be offered lower interest rates and larger loan amounts. They may also get a longer repayment tenure, reducing the burden on monthly installments.

Common Misconceptions about the Impact of Personal Loans on Credit Scores

There are several on how both of these factors affect each other. Here are some of the most common personal loan myths -

• Taking out a personal loan will have a negative impact on your credit score.
• A personal loan is a quick way to improve CIBIL score.
• A high credit score is a guarantee for personal loan approval.
• A higher income will make up for a lower credit score.

Debunking the Common Myths Surrounding Personal Loans and Credit Scores

Myth 1. Taking out a Personal Loan always hurts your Credit Score

When you apply for a personal loan, lenders will initiate a hard inquiry on your credit report. This may cause a small decrease in your credit score, but it is usually only for a short term. If you make sure of timely payment of the loan instalments, you can improve your credit score over time. Moreover, a diverse mix of credit including a personal loan can benefit your score as it shows that you can responsibly manage different types of credit.

Myth 2. Personal Loans are a Quick fix for Improving your Credit Score

It is true that personal loans can benefit your credit score over time, but it is by no means a “quick fix”. Improving your credit score requires consistency in responsible credit behaviour. Some ways to do this include making on-time credit card or loan payments, keeping the credit utilisation ratio below 30%, and not applying for too much credit at once.

Myth 3. A High Credit Score guarantees Personal Loan Approval

While a high credit score will make your loan application stronger, it does not guarantee that your loan will be approved. You also have to meet other personal loan eligibility criteria such as age, work experience, and minimum income.

Myth 4. A Higher Income makes up for a Lower Credit Score

A significantly high income may be considered a good indicator of your repayment ability. However, a low CIBIL score can point toward credit irresponsibility in the past, making lenders hesitant to approve the loan amount.

How can Personal Loans Impact Credit Scores Positively?

Provided you manage them wisely, here are some ways personal loans can improve CIBIL score -

• On-time payments: Making timely loan payments will help you build a positive payment history, the most important factor influencing credit scores.
• Credit utilisation ratio: Personal loans are instalment loans, meaning they do not contribute to the credit utilisation ratio. Using personal loans to consolidate credit card debt can help decrease this ratio that shows how much credit you are using against the credit amount available to you. A low credit utilisation ratio, ideally below 30%, generally has a positive impact on your credit score.
• Improved credit mix: Having different types of credit including personal loans can show lenders that you can manage them responsibly.

Factors to Consider when using Personal Loans to Enhance Credit Scores

While personal loans can be useful for credit score enhancement, they need to be managed responsibly to avoid complications down the road. Here are some factors to keep in mind -

• Borrow only the amount that you can comfortably afford to pay back. Missed payments or defaults will negatively affect your credit score, and can also stay on the credit report for up to 7 years.
• Try to go for lower interest rates so that you have lower EMIs and minimize the overall cost of borrowing. Look out for any additional fees that could affect the total cost of taking out the loan.
• Do not neglect other obligations such as credit card bills and any existing loans. Maintain on-time instalments across all open credit accounts.

Tips for maximizing the Benefits of Personal Loans for Credit Score Enhancement

Here are some ways to get the most out of personal loans for credit score enhancement -

• Keep the loan amount restricted to what you need and do not use the loans for unnecessary expenses that will add to your financial burden. Consider using it to consolidate a high-interest credit card debt, if the personal loan interest rate is lower than the existing credit card debt.
• Maintain a good payment history as it often has the most impact on your credit score. Set up reminders or auto-pay to avoid missed payments.
• Do not apply for multiple loans within a short period. Each time a hard inquiry is conducted, your credit score can be temporarily lowered.

Conclusion

Credit score enhancement takes time and consistent financially responsible behaviour. Whether a personal loan will positively or negatively affect your credit score depends entirely on how you manage it. Making on-time payments across all credit accounts and keeping a low credit utilisation ratio will help improve your credit score over time. There may be a temporary, short dip in the credit score as a personal loan application generates a hard inquiry from the lenders.

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