Will taking out a personal loan affect your credit score?

Factors that affect your credit score

In order to understand how a personal loan can impact your credit score, you first need to understand how your credit score is decided. According to Equifax (a data analytics company that determines credit scores), there are several factors that affect your credit score*, each with their own weighting.

While this breakdown is specific to Equifax scores, most credit reporting agencies follow a similar breakdown.

• The type and size of credit requested in your application. Both the type and size of the loan or credit limit you’ve applied for in the past can affect your Equifax Score. EG mortgages or personal loans may have a different level of risk compared to credit cards.
• The number of credit enquiries. Every time you apply for a credit product and a credit provider obtains a copy of your file, an enquiry is noted on your file. If you've shopped around for credit and applied at a number of places all within a short space of time, it may flag you as a higher risk. The pattern of credit enquiries over time also affects the level of risk.
• Directorship and proprietorship information. If you’re a director or proprietor, it may impact your Equifax Score so it’s important to check both the individual and commercial sections of your credit file.
• Age of credit file. The date your credit file was created may impact your Equifax score. A new file may indicate a different level of risk compared to an older file.
• Personal details. Your Equifax Score will consider your age, length of employment and how long you’ve lived at your current address.
• Default information. Default information in your personal or business credit reports, such as debts, credit infringements or clear-outs may impact your Equifax credit score.
• Court writs. Default judgements or court writs may convey you as an increased risk and negatively impact your Equifax Score.

If your credit score is not where you would like it to be, there are plenty of ways you can boost it, positioning yourself as a better applicant when it comes to applying for credit.

Want to find out your credit score and see if you are eligible for credit?

How a personal loan can positively impact your credit score

When used properly, a personal loan can boost your credit score.

Out of all the credit score factors mentioned above, the factor with the highest weighting is your payment history. If your record indicates that you are consistent with making timely repayments in full, lenders assume that you will do the same in the future, impacting your score positively. The more on-time payments you have (and the longer you have maintained it), the better your credit score will be, as it demonstrates that you can responsibly handle debt.

Adding a personal loan to your credit mix can also boost your credit score as it shows that you can handle different forms of debt such as a loan as well as a line of credit.

If you have bad credit or you have never yet established credit, taking out a new loan also gives you the opportunity to successfully build up your credit score. It will improve over time with each monthly on-time payment.

The benefits a personal loan can have on your credit score are:

• By taking on a loan, you start to build up your credit score,
• Paying back the loan on time and in full proves that you are a worthy and valuable borrower,
• Not skipping payments is a sign that you have not taken on more debt than you can afford,
• Taking out a loan (alongside a line a credit) increases your credit mix, showing that you are capable of managing different types of debt.

When a personal loan can negatively impact your credit score

Simply getting a personal loan is not likely to have a long-term negative impact on your credit. However, the improper management of one will.

If you miss payments on your personal loan, you will be penalised with a reduced credit rating, as this can paint you as an untrustworthy borrower who has borrowed beyond their means. This, coupled with overdue bills or other financial negligence will again reduce your credit score as it shows that you cannot manage your debts effectively.

When you apply for a personal loan, an “inquiry” by the bank, on your behalf will be created. If you are making a lot of credit inquiries in a short period of time, it can be a sign that you are in financial trouble and need money, so this will bring your score down slightly. The same goes for loan rejections.

As well as this, when you apply for a loan, the bank will look at your existing debts and compare it to your monthly income, thus creating your debt ratio (how much of your monthly income goes towards your monthly payments). From this, they will decide if you have the capacity to take on more debt. The less debt you currently have, the higher your capacity is. Therefore, while taking out a personal loan can positively impact your credit mix and payment history, it can also negatively affect your amounts owed.

Don’t borrow just for the sake of trying to improve your credit, borrow wisely. We can help you find the right lending product to suit your needs.

Use our handy Borrowing Power Calculator to estimate how much you can afford to borrow

References: https://www.equifax.com.au/personal/help-centre/credit-scores#:~:text=Your%20Credit%20Score%20is%20derived,a%20credit%20risk%20you%20are.