How do Loans Affect Credit Score?

Last Updated : April 6, 2020, 8:03 p.m.

Every person faces a certain situation where he/she would need urgent funds. This urgency can be tackled by opting for a different type of loan provided by several banks and financial institutions. If you have any personal needs such as marriage, travel or a medical emergency, you can take a personal loan. Similarly, you can opt for a home loan if you want to buy, improve, repair, extend homes, etc. Other loans are vehicle loans, loan against property, etc. We can categorize these loans into two categories – Secured and Unsecured Loans.

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But there is a question which bothers individuals who want to take any kind of loan from lenders – How do loans affect their credit score ? Since a lot of individuals don’t know the exact answer, they remain hesitant while applying for a loan. If you are one of them and want to know about how exactly do different types of loans affect your credit score, you don’t need to worry. We will be telling you about this in detail so that you don’t have any doubt regarding the effect of loans on your credit score. So, if you want to know about it, keep reading it!

There is this one thing that you must know that any kind of loan affects your credit score in both positive and negative ways.

What are Different Types of Loans and How Do They Affect Your Credit Score?

As we told before that we can categorize the loans in basically two types – Secured and Unsecured Loans. Under these two categories, there are many kinds of loans such as personal loans, home loans, car loans, loan against property, and others. Apart from these loans, individuals also opt for both secured and unsecured credit cards which also affect your credit score to a large extent. So we will explain how each type of loan and credit card affects your credit score in a detailed way, take a look.

Personal Loan

Let’s start with a personal loan , which is an unsecured loan that means you don’t have to pledge any kind of collateral or security against the loan amount you are getting from the lender. It is one of the most popular banking products that individuals can opt for. As this is an unsecured loan, the obligations of it in the form of EMIs can be higher. So if you pay the EMIs of a personal loan on time, your credit score gets a boost. This helps you in creating a strong repayment history, which will reflect positively on your credit score. Other than this, with the help of a personal loan, you can pay off your revolving credit card debt and then pay off the personal loan in easy installments. Clearing your credit card debt will also increase your credit score.

However, if your repayment shows a payment delay of over a month often, it will highly affect your credit score. Also, applying for multiple personal loans in a short span of time also affects your credit score negatively. This is because lenders make hard credit enquiries to pull your credit report. It could so easily lower down your score. So don’t apply everywhere, instead apply at a lender that offers you the loan at attractive terms and conditions.

Home Loan

Home Loan is also one of the most popular loan products in our country as everybody wants their home but not everybody has the required funds for it. The first thing you need to know about home loans is their secured nature which means that you get the loan amount by putting your home/plot/land as the security to the lender. Your loan amount will also depend on that. The need for checking your credit score before opting for a home loan is a bit low but this doesn’t mean that this does not affect your credit score. The first thing about the home loan is that it helps you in creating a better credit mix. If you have only unsecured credits such as personal loans and credit cards, having a home loan gives you the much-needed variety to your overall profile.

Home Loans usually have a longer repayment period due to the higher loan amount. So if you pay all your home loan EMIs on time, your credit score will only increase. By paying them regularly, lenders could offer you a top-up loan or even pre-approved loans due to your high credit score. For this, you don’t need to submit any documents. This can be applied with just one click. Sp, making timely repayments can fetch you some amazing things apart from increasing your credit score.

Four-wheeler or Car Loan

Same as a home loan, a four-wheeler or car loan is also a secured loan. Your vehicle will act as the security against the loan amount. But despite it being a secured loan, the role of credit score in a car loan is pretty important. This is because the value of cars depreciates sharply over time. So,if you default, the lender might find it hard to recover the total dues even after selling the vehicle. Without having a good credit score (above 700), you will have to face a lot of difficulty in getting the loan. Paying your Car Loan EMIs on time will automatically increase your credit score. In contrast, missing due dates and late payment will impact your credit score negatively. And in the case of default, you can lose your vehicle too which is collateral against your loan amount.

Loan Against Property

For people who cannot get a secured loan due to a bad credit score or any other reason, opting for a loan against property is one of the best ways to increase their credit score. Being a secured loan, when you make timely repayments, your credit score increases with time. Also, it helps you in creating a credit mix in your overall profile as this is a secured loan. Having a better credit mix impacts your credit score in a positive way.

Secured and Unsecured Credit Cards

Other than loans, credit cards affect your credit score depending on their nature and how you use them. Firstly, credit cards are of two types – Secured and Unsecured. For unsecured credit cards, you don’t need to submit any kind of security to the bank while secured cards are given to customers against a fixed deposit. The overall limit of your secured credit card will depend on the value of your fixed deposit. Some of the top secured credit cards are SBI Unnati Credit Card, Axis Insta Easy Credit Card, ICICI Instant Platinum Credit Card, IndusInd Aura Credit Card, HDFC Regalia Credit Card, and others. You can opt for these credit cards if you couldn’t get an unsecured one due to the low credit score.

When you use your credit card intelligently, it can have a positive impact on your credit score and vice- versa. To increase the credit score through your credit card, you have to do a few things such as paying all your credit card dues on or before the due date. If you have delayed the card dues by more than a month frequently, it must have impaired your credit history greatly. Paying the minimum due on the credit card on or before the due date may not impact your credit score if you pay the same on time. But maintaining the habit of minimum due payment can spiral the debt to massive proportions. This could make minimum due much taller than what it is now, forcing payment delays or even defaults. Eventually, it’s the credit score that will take a beating with this sort of payment behaviour. So if you want to avoid them, then it will be better for you to use your credit card in an intelligent way.

Factors through which Loans Affect your Credit Score

Above you saw the effect of different loans on the credit score of individuals, now you’ll get to see the factors that help calculate the score, which ranges from 300 to 900 in India.

Your credit score is determined by factors such as your payment history, current debt, length of current history, credit mix, and current debt. When you take any loan, your credit score gets affected by these factors. The below table shows the weightage of each of these to your credit score. Have a look!

Now we will tell you about each of these points in detail so that you have a clear understanding of how they affect your credit score.

Credit Payment History

This is one of the major factors that affect your credit score. Making timely payments of your loan and credit cards entail almost 35% of your credit score. So, the best way to maintain or increase your credit score is to pay all your EMIs on time whether they are loans or credit cards. By missing your payments and accumulating huge debt both affect your credit score in a negative way. And once it starts going down, you will have a hard time getting the score back to normal.

Before giving any type of credit to you, lenders check your credit score to see if you are punctual with the repayment. Many lenders instantly reject the loan application if you’ve a poor credit score. Even if the loan is sanctioned, the interest rates will be much higher, raising your EMI obligations. So, the key to improve your score is to always make full repayments on time.

Current Debt

The second most important factor is the current debt you’re having. Sometimes it doesn’t affect your credit score directly but it reduces your ability to take up more debt. Before sanctioning any loan to you, lenders check your existing obligations which can be seen through your credit report. Now suppose you already have a huge debt on your name, lenders could reject your fresh application citing a reason that you won’t be able to service any new debt. This can be done by checking your Debt to Income Ratio (DIR). If this ratio of yours is low, then it means that you could get an additional loan. In case the proportion of debt to income increases, your repayment capability weakens accordingly.

So it is not wise to take up loans beyond your repayment capability. This also affects your credit score negatively. When you have a debt amount that you can pay on time, your score will increase. So, do not take loans just for the sake of it as it may hurt your score.

Length of Credit History

This factor also plays a huge role in calculating your credit score. A long credit history automatically indicates you have been managing debts for a long time. And, if it is found that you’ve been paying your dues on time, it could reflect better to your credit history. That’s why we said earlier about how home loans are usually for a longer tenure and how you can get pre-approved loans if you keep repaying them on time.

Maintaining a good repayment track over a long period of time shows that you are perfectly suitable when it comes to handling the debt. Your credit history starts from the exact day when you opt for any credit card or loan for the first time. Having a longer credit history has a positive impact on your credit score.

Better Credit Mix

This factor has a total of 10% weightage on your overall credit score. Credit mix means having a mixture of both secured and unsecured loans. For example, if you have been using a credit card for a long time, and suddenly you are in need of funds for some emergency. Then it would be wise to opt for a loan against property or a loan against a fixed deposit or any other assets as compared to opting for a personal loan. As you already have an unsecured credit card, opting for a secured loan would be a smart choice to give the required variety to your credit profile.

It is not like that your credit score will not improve if you do not have a credit mix, but having a credit mix will improve your score at a much faster rate. But you need to make repayments on time.

New Credit

Having a new credit is also important but you must keep this fact in mind that you must not take a loan just for the sake of taking a new credit. You should apply for the loan only when you need it the most. Taking new credit certainly helps you in increasing your credit length and having a better credit mix, but if you can not repay it on time, it will only impact your score negatively.

So, take a loan after checking your credit requirement, repayment capability and monthly income.

So, these are the factors that you must keep in mind while opting for any kind of loans or credit cards.