Most people often need some form of loans, credit, or borrowings for making big purchases such as a home, car, etc. These could be required even for starting a business. Banks and non-banking finance institutions offer different forms of loans and credit to these borrowers. The different types of credit can include personal loans, home loans, car loans, credit cards, gold loans, education loans, consumer durable loan, to name a few.Lending institutions determine a borrower’s eligibility and credit repayment capability by looking at the applicant’s credit scores that are calculated by credit bureaus. So, what is a credit score and why is it important? Here, we will try to simplify the concept of credit score while also highlighting some of its features, calculation method, importance, among other factors.
What is a credit score?
A credit score is a three-digit number that can range between 300 and 900. This score indicates a borrower’s creditworthiness. The higher one’s credit score, the higher the chances of easily securing a loan or credit from potential lenders.
With the help of a credit score, banks and lenders can get an insight into a borrower’s credit history. Most lending institutions today use credit score as the first checkpoint to evaluate an applicant’s creditworthiness before granting a loan or credit card. Some of the key parameters that comprise a credit score are:
- Open credit accounts
- Existing debt levels
- Forms of credit used
- Value of outstanding loans
- Repayment history
- Credit limit utilization
One of the ways of maintaining a healthy credit score is to keep these parameters in check. Regularly paying off existing debt such as loans or credit card dues ensures that one can maintain a credit utilization under 30%. This. in turn, helps in maintaining an acceptable credit score.
How is credit score calculated?
A credit bureau is an organization that gathers the information surrounding every credit user or borrower’s credit history and related details. These bureaus pass on the gathered information to lenders in the form of credit scores and credit history. They may follow unique scoring models for arriving at the credit scores of borrowers. Credit scores are usually derived through automated processes.
The four primary credit rating agencies in India are:
Among these, TransUnion CIBIL is the first credit bureau to be established in India and one of the most trusted financial entities for credit checks.
Since different credit bureaus have different scoring mechanisms, a borrower’s credit score may have minor variations across the scores offered by each of these. However, the weightage on certain criteria for obtaining a loan would be the same across. Listed below are these criteria:
- Payment history–35%
- Credit utilization – 30%
- Length of credit history–15%
- Credit mix – 10%
- New credit–10%
A credit score is calculated through a mathematical algorithm by taking into account all the variables mentioned above. All these put together help in determining a borrower’s repayment ability, including timing of repayment and amount. A borrower must remember that the credit score can change periodically since it incorporates the latest available data from existing credit accounts.
How does a credit score help lenders and borrowers?
A credit score offers an insight into a borrower’s or credit user’s credit health or creditworthiness. Here’s how it helps lenders and borrowers alike:
1. Insight into current credit standing
A credit score offers borrowers an insight into their current credit standing so that they know whether any improvements are required. With the help of a summarised version of past and present credit pattern, one can identify any issues or gaps that may have caused a drop in the credit score. A borrower can then begin planning various ways to address these and improve overall credit standing.
2. Lowers risk for lenders and increases credit opportunities for borrowers
A good credit score on the borrower’s part always lowers the lender’s risk and reduces the chances of default in repayments. A credit score of 750 or above is considered good by lenders and can fetch good deals on credit for borrowers. Banks and lenders will be willing to grant loans and credit cards with lower interest rates to applicants with high credit scores. Some of the common benefits offered to applicants with high scores include processing fee discounts or waivers and higher loan amounts.
3. Improved chances of credit approvals
A borrower with a good score is considered low-risk and therefore has a higher chance of easily getting credit cards and loan approvals. Applicants of premium credit cards should ensure a high credit score to boost their eligibility. A good credit score widens the opportunities for borrowers to access different credit-lending products, including cards with low-interest rates or rewards, such as travel points and cash backs.
The higher the credit score, the better the chances of getting approval for a higher credit limit on credit cards. Lenders will be interested in lending more money to borrowers whose creditworthiness track record is positive as per their credit score.
Benefits of having a good credit score
There are many benefits of having a good score. Some of these are:
- Banks/NBFCs will be willing to lend loans and credit through easy and fast approvals
- Fewer documentation requirements from borrowers with high credit score
- Borrowers with a good score do not have to produce guarantors for loan applications
- A borrower with a good score is considered as a low-risk customer. This allows him/her to get a lower interest rate on loans or credit cards.
- Processing fees can be significantly lower or even waived off in some cases
- Banks may be willing to offer higher borrowing limits to borrowers with good credit scores
- These days, many employers verify credit scores of potential hires as part of their background checks. Thus, a good score can also help in securing a job.
A good credit score is anything that ranges between 750 and 900. A borrower or credit user may have a score of 900 if his/her credit history is above-par. A high credit score is a reflection of responsible credit behaviour. Here are a few of the ways that a credit user can improve his/her credit score:
Repay on time
Missing repayments on any outstanding debt can negatively impact one’s credit score. It is important to be punctual about paying loan EMIs or credit card dues. Delays in paying these could mean penalties and also impact on credit score. Setting reminders for timely payments is a smart step towards ensuring a good credit score.
Maintain a healthy credit mix
A good mix of secured (loans like home, vehicle loans) and unsecured loans (personal loans & credit cards) reflecting on a borrower’s credit report is preferred by lenders. This also improves credit score of a borrower.
Avoid multiple loans at once
Anyone who is aiming for a good credit score must ensure that existing loans or dues are paid off before taking another one. Multiple loans if taken at the same time reflect financial issues on the part of the borrower. Therefore, it makes sense to take one loan at a time and pay it in its entirety to improve credit score. Your loan EMIs should not take up more than 40-50% of your take home salary.
Lower credit utilization
Spending 30% of the available monthly credit limit on credit cards is an effective way to maintain a lower credit utilisation and ensuring a good credit score. Spending more than 30% of the credit limit indicates that a credit user spends without a second thought and results in a drop in credit score.
A good credit score can mean monetary savings and multiple other benefits, like easy availability of credit at favourable terms and conditions. As banks and lenders continue to focus on credit scores to gauge creditworthiness of borrowers, borrowers need to place higher importance on maintaining a good score at all times. Seasoned credit users maintain old credit cards and periodically use them to strengthen their credit history and ensure a good credit score.
To check your credit score, you can visit the website of any of the reputed credit bureaus. The basic credit score information is usually available for free while a detailed credit report may have to be paid for.
A credit score ranging between 300-550 is usually considered as a poor score and is an indication of lack of creditworthiness on part of the borrower or credit user.
Building credit usually takes a few months to a few years, depending on a borrower’s credit utilisation. However, to build credit faster, one can aim to maintain a consistent and above-par credit behaviour.
There are usually lower chances for a defaulter to get a loan unless an exception is granted by the lender, especially for unsecured personal loans, which may come with substantial interest rate charges.
Banks and lenders mostly use credit scores published by CIBIL, Equifax, or Experian in India.