Understand what is a credit score: For anyone taking a loan from a bank, it is important for them to have a credit score. What is a credit score? How is it calculated?
If we have an existing loan going on or want to take out a new loan, we need to understand what our credit score is. A credit score is a type of scoring system that determines the probability of receiving a loan from a financial institution.
Simple Interpretation Of Credit Score
In simple terms, if our credit score is better, the probability of getting a loan is higher, and if the CIBIL score is bad, the probability of receiving a loan is lower, and even if they receive a loan, they might have to pay a higher interest rate on it.
So it is important to learn what is a credit score and how it is calculated. This article is all about credit scores and how they are calculated.
Credit scores are usually calculated by the government or third-party entities. These entities keep a record of all the people who have taken a loan, at any point in time. This information is required by banks.
When we apply for a loan at the bank, we have to submit certain documents like salary slips, income statements, income tax returns, proof of identity, and many other documents.
After all, the bank wants to know what we have done in the past, what our current financial situation is, how we spend our money or what we spend it on, how many other loans we have, and how many loans we have taken.
When we apply for any type of loan from the bank, the bank asks these third-party entities to provide details about our personalized credit history, which is called a credit information report.
These entities give ratings or scores based on our history of credit. This is called a credit score.
To simplify what is a credit score, it is a number that is between 300 and 900. A score of 300 means a very bad score, meaning it is hard for a person with this score to get a loan, and even if they do, they have to pay a higher interest rate.
On the other hand, 900 is a very good score, meaning the person with a score of 900 is more likely to pay the loan. A good credit score is above 750.
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Factors Affecting Credit Score
Here’s the list of various factors that affect the credit score –
1. Repayment History
Repayment history is the most important factor that affects a credit score. This is information regarding our past payments of loans and defaults, and how consistent we were with paying loans.
This contains all the information regarding payments, late fees, dues, and fines for the loans we have taken before. This includes EMIs, credit card payments, and so forth. This is to measure how good we are at paying off our loans.
2. Mix Of Loans
There are two types of loans: secured and unsecured. Secured loans are loans that are secured by an asset or where we have taken a mortgage on the asset.
For example, a home loan where the home is the asset we are taking a loan on. Unsecured loans are loans where there is no collateral from an asset.
For example, with a credit card, there is no guarantee that we will pay it back. We take it as credit.
Having a higher percentage of secured loans will make our credit score higher, and having a higher percentage of unsecured loans will make our credit score lower.
3. Credit Limit
A credit limit is the amount of loan that one is capable of paying back. The calculation of a credit limit is based on factors like income, collateral, age, and other factors. If someone has exceeded their credit limit, their credit score will go down.
For example, if a person’s credit card limit is set at 50,000 per month and he spends somewhere close to 40,000, he is almost maxing out on their credit limit, which will bring down the person’s credit score, and if he maxes out his credit every month, he can’t obtain other loans, or even if he does, he has to pay a higher rate of interest.
4. Applying For Multiple Loans
Applying for multiple loans at the same time will reduce our credit rating.
When we apply for a credit card, before issuing, the bank will check our credit information report, and if we have applied for more than one credit in the same period, it will form a bad impression in the banker’s eye.
Having had a loan application recently rejected, it is not recommended to apply for another one immediately. It is better to apply once the credit score is high again.
5. Being A Guarantor For A Defaulted Loan
Signing as a guarantor for someone’s loan and if they don’t pay it back or default on it will reduce the guarantor’s credit score.
For example, if your friend is taking a home loan and he asks you to sign as a guarantor that he will make consistent payments towards the loan, but he ends up not paying it back and defaults on the loan, your credit score will also go down with his.
Being legally associated with a defaulter will also reduce the credit score.
How To Get Our Credit Score?
In India, we use a metric called the CIBIL score, which is a credit score. CIBIL is a private organization that records all our credit details and provides them to the bank.
To check the scores, we have to log in to their website and fill out certain details, and we will get our credit score.
It is recommended to check your credit score once a year.
How to Increase Our Credit Score?
Now let’s look into the ways to increase our credit scores –
1. Pay All Outstanding Credit Dues Full And In Time
Paying all the EMI’s timely and in full helps to get your credit score back on track. This applies to credit card bills too. Credit payment history plays an important role in the calculation of credit scores.
Avoid late payments of credit card bills; this always hurts the credit score. One tip from our side is, to automate your credit payments through a bank; that way, we don’t have to worry about time.
2. Aim To Use Less Than 35% Of Your Credit Limit
A credit limit is the maximum amount of a loan that a person is capable of repaying. A credit limit is determined by factors such as income, collateral, age, and others. If a person exceeds their credit limit, their credit score will suffer.
For example, if your credit limit is Rs. 1,00,000 per month, try to keep your spending to less than Rs. 35,000 per month. This will increase your credit score.
Pro tip: If you have recently had a loan application rejected, it is not advisable to apply for another one right away. It is preferable to reapply once the credit score has improved.
3. Getting A Credit Card
For someone who has never taken a loan in their life, their credit score will be zero. For them to get a credit score, they can start by using a credit card.
A credit card is very helpful in building a credit score, but it is also important to remember that we pay it on time and avoid any dues or fines.
If someone is just starting their career, it is recommended for them to use a credit card with a lower credit limit so that they can use it and build their credit score. It usually takes 12 months or more to build a credit score.
4. Have A Credit Mix and Check Your Credit Score Regularly
Having a mix of both secured and unsecured loans, having secured loans like home loans and car loans will boost our credit score, and paying off unsecured loans like credit cards and personal loans on time will build a reputation with banks.
Having a mix of both of these is beneficial.
It is recommended to check our CIBIL scores once a year and fix the errors related to them. Credit scoring agencies make mistakes, so it is better for us to check them and rectify them.
To sum up, what is a credit score is a metric that checks out the probability of how likely someone will default on their loan if they are eligible to get a loan or not.
Having a CIBIl score of 750 means the probability of default is lower. A person’s credit score is determined by their repayment history, credit limit, and how many outstanding loans they have.
Having a good credit score will help us get loans easily, quickly, and at a lower rate of interest. It will also make us responsible citizens. It will also open up benefits in the future.
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