In this Article:1. How is a Credit Score Calculated?2. How does Loan Application affect your Credit Score?3. Conclusion
A credit score simply assesses the creditworthiness of an individual. Generally, the lender checks the credit score of his respective borrower to ensure their ability to repay the loan. In today’s world, a credit score is no longer only significant from the lender point of view, but individuals are becoming more conscious regarding their credit scores irrespective of the fact they want to borrow or not. Everyone is concerned about maintaining a good credit score and being creditworthy. Before we jump to the question “Does Applying for Loan Affects Credit Score”, let us first understand how a credit score is calculated and what are the factors affecting it.
How is a Credit Score Calculated?
Whenever you apply for any kind of loan or credit card, the first thing your lender does is to check your credit score. Thus, having a good credit score is key to getting loan approval quickly and on better terms. Your every credit action affects your credit score. A large number of factors affects your credit score. It is good to know about some of these factors which are as follows:
- Credit Repayment History: Your credit repayment history shows how consistently you are making payments to your lenders. The timely payment of your instalments and loans boosts up your credit score.
- Credit Utilization Ratio: This ratio demonstrates your total credit limit and the credit you had utilized till now. The lesser the credit you use, the better will be your credit score. The ideal credit utilization ratio is 30% as a very high ratio could have an adverse impact on your credit score.
- Credit Age: Your credit age is calculated from the date your first credit was sanctioned. The older your credit age gets, the better will be your credit score.
- Errors in your CIBIL Report: You should regularly check your credit reports to avoid any errors that may adversely affect your credit score.
- Hard & Soft Enquiries: Whenever, you apply for a loan or credit card, your lender verifies your credit score and credit reports from the credit bureaus that issued your report. This is known as Hard Enquiry. Soft Enquiries refers to checking your credit scores on online platforms such as Paisabazaar.
- Credit Mix: Credit Mix measures the amount of unsecured and secured loans in your loan portfolio. You should at least have one secured loan account with a long debt period. Exposure to more secured loans keeps your credit score in line as compared to unsecured loans.
- Credit History: If you have a long credit history of responsible behaviour then it might help you to boost your credit score.
How does Loan Application affect your Credit Score?
Loan Applications has the ability to affect your credit score. Loan Applications impacts the following factors that are crucial for calculating the credit score:
- Submission of Loan Application: In the loan application process, you need to submit your application for the loan with all the relevant details required by the lender. As mentioned earlier, each credit action bears an impact on your credit score and so does an application to loan. The lender assesses your creditworthiness by checking your credit score and by conducting hard enquiries.
- Effect of Hard Enquiries: We already know that the process of enquiring with the credit bureau by the lender about the credit score of the borrower is known as a hard enquiry. In usual cases, hard enquiries cause a credit score to drop by around 5-10 points, but the impact of this decline fades away over the course of 12 months or so. You may be looking for the best credit terms and thus may conduct multiple credit enquiries over a short time span. These multiple inquiries will not adversely affect your credit score if conducted over a small-time frame as these are grouped into one hard enquiry (the time period may range between 14-45 days depending on the type of loan and credit-scoring model). Despite this, a large number of hard enquiries is not perceived good by the credit bureau or the lenders as no lender would like to lend to a person who presents a risk of not repaying the loan on time.
- Effect on Credit Mix: As a credit, mix refers to the combination of secured and unsecured loans, the loan you apply for will definitely affect your credit mix that further affects your credit score. The impact of this factor depends on your existing credit mix or portfolio and the kind of loan you are applying for. This may affect your credit score negatively or positively.
Kind of Loan Applied for:
|Existing Credit Mix has more of Unsecured Loans||Positive||Negative|
|Existing Credit Mix has more of Secured Loans||Positive||Positive|
- Other Factors: When you apply for a fresh loan, in addition to the above factors, your current income level and your existing debts and liabilities also affect your credit score.
Apart from all the factors above, applying for new loans has the potential to affect how lenders view your creditworthiness in ways not depicted by your credit score. Lenders look for your ability to repay the loan and if more of your money is earmarked for other loans, new lenders will view you as a risk.
Credit is an essential part of your financial life. You should only avail of loan facilities if it is necessary for your needs and not as a habit. You should only borrow to the limit you can comfortably payback. You should also keep in mind the impact your loan application shall have on your credit score as bad credit scores might impair you from availing of credits in future. It is also a good idea to avail of loans by keeping time gaps between them to avoid any negative effect on your credit score.