Personal loans are a great way to arrange fund during any emergency of any kind. In case you have to pay a lump sum for medical treatment, plan an urgent trip, organize a marriage ceremony or there is a monetary expense for higher studies, a personal loan is the best thing to opt for owing to its exclusive advantages and perks. It is an unsecured type of loan, which does not require the borrower to pledge any collateral. Added to this is the benefit that a personal loan has unrestricted usage, meaning that one can use the amount for any purpose and any number of times.

However, despite being different from all other kinds of loans in the form, a personal loan, just like any other loan, effects the borrower’s credit score. How does it do? We will dwell more into this but before that, it is important to note that before placing any application, you must use a personal loan calculator to have a prior idea of how your amortization period will look like. Using a personal loan calculator will help you in pre-budgeting and plan finances better to eliminate the possibility of any financial crunch in future. Having understood that, let us proceed to know how applying/getting a personal loan will affect your credit score.

Applying for a Personal Loan

When you apply for a personal loan, the bank/lending institution makes an enquiry of your credit rating to a credit agency. The enquiry so made is a hard enquiry and this reduces the credit rating of the borrower by around 3-5 basis points. This means the number of enquiries made, the more will the credit score get affected. On the other hand, when you request your credit rating from a financial institution or any online site, you are making a soft enquiry. Unlike the hard enquiry, a soft enquiry made by an individual without the intention to apply for a personal loan does not affect the credit score in any way.

Paying EMIs

There can be two cases, either you are paying your EMIs on time or you are missing payments. As obvious as it is, in the first case, your credit score will get regular increment by some basis points since you are paying EMIs on time. On the other hand, missing payments will affect your credit rating negatively. Hence, it is always advised to use a personal loan calculator and calculate the EMIs on different interest rates and amortization periods. Proper planning will help you to allocate budget for future EMI payments and decrease the chances of missing the same.

Loan Settlement

Loan settlement means paying a minimum amount of the outstanding principal instead of the entire remaining EMIs. Banks usually pursue you to opt for a settlement when you are missing multiple payments and have also accepted your difficulty in paying the EMIs. Although it may seem a fruitful option in first case, this reduces your score by a fair amount. The unpaid amount is recorded as a loss on the side of the lender and the same is passed to the credit rating agency. The credit rating agency, in turn, considers this as poor financial management and hence prepare your credit report accordingly.

Prepayment and Foreclosure

In general, prepayment of a personal loan or its foreclosure has a positive effect on your credit rating. This is because paying off loans is always considered as a healthy habit. However, this is not obvious for every case. Continuous foreclosures of personal loans is also seen as poor financial management. This is duly taken into account by credit rating agencies while preparing your credit report. The best way to avoid unnecessary foreclosures is by borrowing as per needs and not the basis of your eligibility. Use a personal loan calculator to assess your repayment ability and apply for an amount that you actually require.

Multiple loans

Having one or two open personal loan accounts is fine but if you have more than that then this adversely affects your credit utilization ratio and subsequently decreases your credit rating. Hence, it is recommended that you should close existing loan accounts before applying for a fresh personal loan. Besides, you should also maintain a healthy credit mix and take secured loans as well. Secured loans have much positive effect on your credit score than unsecured loans.

Having learned the aforementioned points on what effect does a personal loan has on one’s credit score, it is important to put the same knowledge into use. Paying EMIs on time, doing homework before applying for a loan, avoiding unnecessary settlements and pre-closures, and using a personal loan calculator are always counted as good habits in the finance sector. Nonetheless, these habits develop as you dwell deeper into the financial sector but in doing that, avoiding risks must be your priority in any case.

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