A credit score has no longer remained a number which is important only from the perspective of lenders. As quick access to credit assumes more and more significance, everyone seems to be concerned about maintaining a good credit score and being creditworthy at all times. This has been aided by the fact that there are more and more fintech firms that allow individuals to check their credit score at any time.
While individuals understand the importance of credit score and that it is necessary to be eligible for any form of credit, not many are aware of the factors that contribute to the credit score. As an example, we bring to you the case study of one of our clients from Mumbai.
Rakeysh (name changed) worked as a Equity Analyst in Mumbai with a well-known company. Thanks to his employment with a well-known company, he did not have any problem getting his first credit card. Initially, he was very careful about spending and paying back on time. But soon enough due to certain reasons, he started borrowing for all his expenses. These loans were quite frequently borrowed.
A few years down the line, he decided that he needed a higher qualification and decided to pursue his Masters from a University abroad. As he lacked enough in savings, he applied for an education loan.
His loan was rejected. On prodding further, he understood that he had a high number of hard inquiries and also an unfavorable credit mix. He had to wait till he closed most of his personal loans to be eligible for an education loan.
From the study above, it is quite evident that it is the excess loans that resulted in rejection of loan.
So for the fear of lowering of your credit score should an individual not apply for any loan? How many loans can a person hold so as to not damage the credit score? We understand that these may be some of the questions running on your mind.
CreditMantri takes great pride in being your Credit Coach and will provide you with answers to all your questions related to credit and credit score.
How is A Credit Score Calculated?
Before proceeding with understanding if applying for loans affects your credit score, it is important to understand how a credit score is calculated and what are the factors affecting it. On broader terms, every credit action of an individual affects his/ her credit score. However, it is good to know about the factors affecting your credit score.
Your Credit Accounts: This includes all your loans and credit card accounts and if these accounts are in the positive or negative.
Repayments on Existing Credit: Regular repayment on existing credit accounts is one of the cornerstones of a good credit score.
Credit Utilisation Ratio: This factor takes into account your credit card usage pattern. Lower ratio of utilization is preferred.
Credit Mix: This feature measures the amount of unsecured and secured loans in your portfolio. Credit Bureaus and lenders look for a healthy mix of both.
Credit History: A long history of responsible behavior with credit is also one of the factors that adds up to your credit score.
Hard inquiries: When you apply for credit, your lender checks for your credit score and credit report. Frequent hard inquiries does not augur well for your credit score.
Additional Reading: 7 ways in which a bad credit score can affect your life?
Which of the Factors Determining Your Credit Score Get Affected When You Apply for a Loan?
Let us consider the kind of impact a loan application can bear on various factors that are important for calculating your credit score.
Loan Application Stage
The first step you take is submitting your application for a loan. As we have said time and again, each credit action bears an impact and so does an application to loan. A lender does not know you personally; the only way they can assess if you are a creditworthy customer is by checking your credit score.
Effect on Hard Inquiries
Credit bureaus assign credit scores to all individuals (and to corporates too) and are the sole custodians of your credit scores. Whenever a lender receives an application for any form of credit (loans or credit cards), they need to inquire about your credit score and credit report with the credit bureau they are affiliated to or are members with. This process of inquiring with the credit bureau about your credit score is known as Hard Inquiry.
There are no points for guessing what happens when you apply for a number of loans in a short period of time! Yes, obviously you have an increased number of hard inquiries. When you have an increased number of hard inquiries in a short period of time or regularly over a longer period of time, this sign is not perceived kindly by the credit bureau or the lenders.
You are thought of as a credit hungry person who is not able to manage his/ her expenses within his income. No lender would like to lend to such a person as he/ she presents a risk of not repaying the loan on time.
So what do you think is the right number of hard inquiries that one could have and yet not see a drop in credit score. For this, we have some simple pointers:
The first and the foremost thing is to try and have a budget and live well within your means.
Apply for loans only when you really need them, such as to build an asset (a home, buying a vehicle, etc).
Avoid unsecured or consumption based loans unless absolutely required.
Apply for a loan that is commensurate with your income.
There is no right number of hard inquiries; it might be good to keep a gap within your loans.
Effect on Credit Mix
Credit Mix is the combination of unsecured and secured loans in your credit portfolio. An individual is considered to be creditworthy if the loans availed are not only used for consumption but also used for building long-term assets.
The loan you apply for will also have an impact on your credit mix. However, the impact on this factor will depend on your existing credit portfolio and the kind of loan that is being availed. There could be a negative or a positive impact.
There could be multiple scenarios possible as given below:
|Loan Applied For||Secured Loan||Unsecured loan|
|When the Existing Portfolio Consists more of Secured Loans||Positive||Positive|
|When the Existing Portfolio Consists more of Unsecured Loans||Positive||Negative|
In addition, the income level and level of existing debts will also play a major factor here.
Credit is an essential feature of our financial lives and there are lenders who are more than ready to lend to us. However, the important point to be kept in mind is that credit should be availed only when it is necessary and not as a habit. And borrow only as much as you can comfortably pay back within your means.