If you’re shopping for a personal loan, one of the most important factors affecting your loan approval is your credit score.
In this guide, we will review the importance of your credit score, how to improve your chances of obtaining a favorable loan, and strategies to help improve your credit profile.
Understanding the importance of credit score in loan approval
When you submit formal loan applications to prospective lenders, they will assess your creditworthiness. Creditworthiness is the extent to which you are reliable when it comes to repaying debt, paying off your loans, managing credit, and maintaining financial stability.
One of the most important factors determining whether you will secure a loan with favorable terms is your credit score.
Factors that affect credit score and loan approval
Plenty of different factors affect your credit score and loan approval, both of which are closely linked with each other.
Here are the five major factors that influence your credit score:
- Payment history
- Credit utilization
- Credit history length
- Credit mix
- New credit
Additionally, here are some of the main indicators of your creditworthiness that lenders may look at when you apply for a loan:
- Your debt-to-income ratio
- Information on your credit history, including negative items such as past foreclosures, bankruptcies, tax liens, and loan defaults
- Employment stability
- The existence of a co-signer to the personal loan
- The valuation of any collateral assets used to secure the loan
To increase your chances of getting approved for a personal loan, it is advisable to practice healthy financial habits and credit score management.
How to check and monitor your credit score regularly
Monitoring your credit score lets you stay in control of your credit and spot any fraudulent or unauthorized changes. It is a good idea to regularly check your credit score to be aware of your creditworthiness and detect potential issues before they worsen.
Here are steps you can take to look at your own credit score.
1. Contact a credit bureau
There are three major credit bureaus: Equifax, Experian, and TransUnion.
2. Get your free annual credit report
You can retrieve your free annual credit report once from each of the three major credit bureaus every year. This can be done by visiting AnnualCreditReport.com, where you can request the reports.
Many individuals may benefit from staggering the credit report requests, that way they can check their credit reports for free throughout the year.
3. Use credit monitoring services
Many financial institutions and platforms offer credit monitoring services. They may be able to give you frequent updates on your credit score. A convenient feature of credit monitoring services that benefits many people is that they can alert you whenever there is a significant change in your credit report.
4. Dispute any incorrect information
If your credit report shows erroneous information, it is essential that you dispute this information as swiftly as possible. These changes may be signs of fraudulent activity or serious mistakes from companies that provided information to the credit bureaus. If you spot discrepancies on the credit report, reach out to each of the three major credit bureaus so that any errors can be rectified before they hurt your ability to receive a loan.
Ways to improve your credit score for loan approval
Since your credit score can greatly impact your chances of obtaining a loan, it is advantageous for anyone seeking a loan to try and boost their credit score.
Here are effective methods that help people improve their credit scores for loan approval:
Pay your bills on time
Making late payments can deter lenders from trusting you with loan funds. Try your best to consistently pay all of your bills in a timely manner before they become counted as late payments. Improving your payment history is a great way to increase your credit score in the long run.
Pay down your credit card balances
Reducing your credit utilization is a relatively quick and straightforward way to improve your credit score. Aim for a credit utilization ratio below 30% by paying down your credit card balances so that your total credit usage decreases. Of course, if you can reduce your credit utilization ratio to below 10%, that may have even better effects on your credit score.
Avoid closing old accounts
Having a lengthy credit history can benefit you by raising your credit score. If an old, unused credit account has minimal annual fees and good standing, it is often a great idea for your credit score to keep that account open.
Diversify your credit
Improving your credit mix by adding new accounts could help you enhance your credit score. However, this has its risks because you may end up taking on more credit than you need. In addition, it is not advisable to open up too many new accounts in a brief period of time, since this suggests to creditors that you might be in dire need of funds.
Examples of credit accounts you can use to diversify your credit include retail accounts and credit cards.
How to dispute errors on your credit report that may affect loan approval
Errors on your credit report may come in the form of fraudulent activity (such as someone stealing your credit cards) or unauthorized inquiries (such as credit checks done without your consent). Regardless of the cause, an error on your credit report could hurt your likelihood of obtaining a personal loan.
To dispute an error, you will need to contact each credit bureau individually since Experian, TransUnion, and Equifax will not share the dispute with each other.
Regularly monitor your credit report so that you can quickly spot and dispute any suspicious changes. A credit monitoring service may be a convenient way for you to receive prompt alerts whenever there is a new credit score fluctuation.
The impact of late payments and defaults on loan approval
If you have made late payments or defaulted in the past on your debt obligations, these negative items will appear on your credit report. A single late payment on a balance could result in your credit score dropping by around 100 points.
Defaulting on a loan has even worse effects on your loan approval odds. Seeing a loan default on a credit report tells creditors that it is highly risky to lend money to that individual.
If you default on a loan or make late payments, it may stay on your credit report for up to seven years.
How to maintain a good credit score after loan approval
If you have successfully obtained a loan, congratulations! You have now secured the loan funds for versatile use. However, it is still essential to maintain a good credit score. A personal loan does put you into debt, which opens up certain risks associated with your new debt obligation.
Here are example situations in which your credit score could drop due to loan approval:
- Not adhering to the loan agreement
- Defaulting on the loan
- Late payments
- Each hard inquiry made on your account can dip your credit score
Here are some steps borrowers can take to increase their chances of maintaining a good credit score after loan approval.
Make loan payments on time
One of the best ways to ensure your credit score stays healthy is to make regular, on-time payments. Your loan agreement will designate how your debt payments should be made throughout the loan tenure until the loan’s maturity date.
Typically, secured and unsecured loans are repaid by paying monthly loan installments to the lender. In some cases, you may be expected to pay weekly or biweekly.
Common loan repayment types include:
- Principal and interest
- Capitalized interest: if you fail to make payments and interest accrues
- Balloon payment: One larger payment at the end of the loan term
Keep a low credit utilization ratio
Many borrowers will try to lower their credit utilization before they apply for a loan. This is because a high credit utilization ratio can hurt their loan approval chances. However, after receiving the loan funds, it is still advisable to maintain a low credit utilization ratio when possible.
Ideally, you want to avoid going above a 30% credit utilization ratio. If you cross this threshold of credit utilization, your credit score may start decreasing. In addition, it is generally a good idea to avoid maxing out your credit accounts.
The role of credit utilization in loan approval
Credit utilization plays an important role when it comes to loan approval. It refers to the amount of revolving credit you are using and reflects how responsible you are in managing credit and debt.
Lenders generally assess it in the form of your credit utilization ratio. This ratio is calculated by taking your total revolving credit balances and dividing that amount by your total credit limits.
A high credit utilization ratio can negatively affect your loan approval process. It could even directly result in a lender rejecting your loan application if it is excessively high. If you are seeking a personal loan, it’s wise to reduce credit utilization since it is an important indicator of your level of lending risk.
What credit utilization should I have for loan approval?
Ideally, you should try to maintain as low a credit utilization as you can, preferably below 30%. A low credit utilization ratio can boost your likelihood of getting your loan application approved by prospective lenders.
If you have a significantly high credit utilization ratio, lenders will view you as a high risk borrower who will not be able to adequately repay the loan. That would greatly reduce your chances of securing a personal loan.
How to negotiate loan terms based on your credit score
Depending on your credit score, you might want to go into personal loan negotiations with different strategies in mind.
Excellent Credit: Excellent credit is relatively rare. It greatly increases the chances of you successfully asking for better loan terms. If you have an excellent credit score, it may be a good idea to ask for lower interest rates, a more suitable loan tenure, or other adjustments to your loan agreement that benefit you.
Good Credit: When negotiating for better terms with loan credit, you may want to emphasize that you have a good track record of repaying debt and managing credit responsibly.
Fair Credit: It can be harder to gain more favorable loan terms if you have fair credit. Being polite and willing to compromise on loan terms are simple strategies for negotiating better loan terms if your credit is not particularly impressive.
Poor Credit: If you have bad credit, your prospective lenders might ask you to explain why there are certain derogatory marks on your credit report. While it is unlikely you will be offered good loan terms with low interest rates, it may still be worth the attempt to negotiate for better terms. Be prepared to explain your credit history in a calm and polite manner.
The consequences of loan rejection on credit score and future loan applications
The consequences of applying for a personal loan and being rejected are typically not serious unless you frequently and excessively apply for loans.
Applying for a personal loan results in a prospective lender performing a hard inquiry (AKA hard credit check) on you. As they access your credit report to judge your creditworthiness, your credit score will see a temporary dip.
Each hard inquiry may decrease your credit score by up to five points. However, the effects of multiple hard inquiries can stack up, leading to a more palpable negative impact on your credit score.
How to mitigate the credit impact of loan approval
There are two main ways to mitigate the negative consequences of applying for loans.
Pre-qualify for a loan: By shopping around for personal loans through pre-qualifications, lenders will only do soft inquiries, which do not affect your credit score. This allows you to quickly and conveniently apply for various loans in a brief period of time.
Apply for loans strategically: Depending on the type of loan you apply for, doing all of your loan applications in a short time frame may reduce the effects of hard inquiries. Both FICO and VantageScore have their own guidelines about how to best mitigate the consequences of hard inquiries if you are shopping around for different personal loan rates.
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