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How does taking a personal loan affect your credit score?

How does taking a personal loan affect your credit score?

Many Aussies use a credit card to pay for their shopping, holidays, and even household and vehicle maintenance. However, credit card companies charge a significantly higher interest rate, making personal loans an attractive alternative for some borrowers. 

But taking on a personal loan is also a financial act; lenders will report it as a credit transaction to credit rating agencies. Typically, both the personal loan size and your ability to make timely repayments can affect your credit score. 

Some lenders may not require a credit check for certain sized loans; such as payday loans that do not exceed $5,000. However, these loans often charge expensive fees.

Does applying for a personal loan affect your credit score?

Applying for a personal loan can affect your credit score in several ways, with the purpose, amount, and term of the loan all playing a part. When a lender requests your permission to access your credit file, it may affect your credit score as it’s marked on your credit history. If you check your credit report, you’ll find that any lender you’ve applied for credit with has reported the application to the credit bureau. This means that your credit score can also be affected if you’re frequently applying for loans, often within a short duration and, in particular, soon after a previous credit application has been rejected. Such incidents can affect your credit score negatively.

On the other hand, a personal loan can help you consolidate your debts or reduce your overall debt burden by helping you pay off a higher-interest loan or credit card. If this is the purpose of your personal loan, applying for it will leave a mark on your credit file. Still, reducing or eliminating debt can help you improve your credit score. 

Taking out a personal loan doesn’t need to be the only solution for a bad credit score. You could, for instance, work on ensuring you earn a steady income and pay your bills or other debt instalments on time. You could also speak to a financial advisor to see if you’ve missed any alternative ways of recovering from excessive debt or bad credit. 

How does taking a secured personal loan affect your credit score?

A secured personal loan can be more attractive than an unsecured loan as you’re likely to get lower interest rates. From a lender’s perspective, a secured loan may present less risk of losing their money. If you default, they can sell the asset the loan is secured against and recover at least some part of the loan amount. 

However, as a borrower, if you’re already struggling to pay off your debts, taking out a secured personal loan could mean risking a bigger default and losing the asset in the process. Borrowers looking to consolidate their debts into a single personal loan could end up facing a significant hit to their credit score if they default on a secured personal loan.

Personal loans also tend to be smaller, purpose-specific debts, for which many lenders do not expect any collateral. For some smaller loans (such as payday loans), lenders may not request a credit check, though you’ll still need to provide proof of a steady, sufficient income to cover the repayments. 

Consider looking for personal loans that allow you to pay more than the scheduled repayment amount and perhaps even giving you a redraw option. Ideally, a short-term unsecured personal loan with no early repayment fee may help you balance loan costs against the potential effect on your credit score. 

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This article was reviewed by Personal Finance Editor Mark Bristow before it was published as part of RateCity's Fact Check process.

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