During a financial emergency, you took a five-year personal loan. You paid all instalments on time and successfully closed the loan on time. You are feeling proud of your achievement. However, after repaying the loan, did you notice a drop in your credit score?
Your credit score calculation depends on factors such as timely repayments, credit utilisation ratio, credit mix, credit age, number of credit applications made within a specified time period, among others. After repaying the personal loan, some of these factors may impact the credit score. In this article, we will understand the impact of personal loan closure on your credit score.
Change in credit mix
One of the factors considered for calculating an individual’s credit score is the credit mix. A mix of secured and unsecured credit products contributes towards increasing an individual’s credit score. The secured credit products include home loans, vehicle loans, etc., which are secured by the underlying assets, such as a house, a car, etc. The unsecured credit products include personal loans, credit cards, etc.
Suppose an individual has a credit mix of one secured loan (a home loan) and one unsecured loan (a personal loan). The home is usually for a longer tenure of up to 20 years, whereas a personal loan is for a shorter tenure of up to 5 years. The individual repays the personal loan and is left with the home loan only.
In such a scenario, the individual’s credit mix will change from a combination of one secured and unsecured loan to one secured loan only. It will make the entire credit portfolio secured, with no unsecured credit products. The change in the credit mix (having only secured credit and no unsecured credit) will contribute negatively towards the individual’s credit score.
So, when you close a personal loan, check whether it has altered your credit mix from a combination of unsecured and secured loans to secured loans only. In such a scenario, due to a change in credit mix, the credit score may dip by a few points. However, over the next few months, the credit score will recover, provided there are no additional adverse changes.
A short-term loan may halt progress in the credit score
Suppose you have never availed of any credit instrument in the past, and hence, don’t have a credit score and history. You take a short-term personal loan with a 6-month tenure. When you start repaying the EMIs, you begin building a credit score and a history.
You pay all the EMIs on time. However, when the personal loan repayment is complete, it will halt further progress in building credit history. As the personal loan is the only credit instrument that you have availed of, its repayment will stall the progress in your credit history.
Credit ageing
Credit ageing is one of the factors considered in calculating the credit score. The longer the credit ageing, the better it contributes towards increasing your credit score. Suppose the personal loan that you just closed was the credit instrument that you held for the longest time among all other credit instruments. In such a scenario, credit ageing will be reduced. It can result in a slight fall in the credit score. However, the credit score will recover over the next few months, provided there are no additional adverse events.
Reduction in debt-to-income ratio
In the earlier section, we understood how the closure of a personal loan can adversely impact an individual’s credit score. However, the closure of a personal loan has a positive impact on the debt-to-income (DTI) ratio.
The DTI ratio measures the percentage of income going towards paying loan EMIs. Suppose Karan’s monthly salary is Rs. 1,00,000, out of which Rs. 35,000 goes towards paying EMIs towards 3 loans. Karan’s DTI ratio is 35%. Banks consider a DTI ratio of 30% or lower to be favourable for approving loan applications.
Karan completed the repayment of a personal loan with an EMI of Rs. 15,000 this month. With the personal loan repayment completion, Karan’s DTI ratio has fallen from 35% (Rs. 35,000 going towards loan EMIs) to 20% (Rs. 20,000 going towards loan EMIs).
The reduction in DTI to 20% opens up space for Karan to avail of more loans, if there is a need. As mentioned earlier, banks consider a DTI ratio of 30% or lower to be favourable for approving loan applications. As Karan’s DTI has fallen from the earlier 35% to the current 20%, banks will consider his loan application favourably, provided he meets the other loan eligibility criteria.
Therefore, the closure of a personal loan can lead to a fall in credit score due to various reasons. However, the benefit is that with the reduction in the DTI ratio, it opens up space for new loans, provided there is a need.
A decline in credit score is temporary
We have discussed the various scenarios in which an individual’s credit score may decline after a personal loan closure. In most cases, the credit score fall is by a few points and is temporary in nature. The credit score usually recovers over the next few months, provided the individual makes timely payments, maintains a credit utilisation ratio of 30% or lower, and makes one credit application at a time. As the credit score fall is temporary, you should celebrate your personal loan closure rather than wondering about why the credit score has fallen.
Gopal Gidwani is a freelance personal finance content writer with 15+ years of experience. He can be reached on LinkedIn.
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