What is a credit score?
A credit score is calculated using proprietary formulas using credit history data found in credit reports. This score is affected by several factors such as payment and lending patterns, number of credit card or loan applications, and credit utilization. The formula used to calculate credit score varies from one credit bureau to another credit bureau, so an individual’s credit score may vary from bureau to bureau. A credit score plays a major role in getting the loan or credit card application approved. If the applicant’s score is near 900, then he/she is more likely to get approved for a new credit card/loan.
What Does Your Credit Score Start At?
As mentioned above, in the starting period most people will start at a credit score which is around 500. This is based on the calculations of FICO percentages and also on your corresponding performance within those six months. If you opened just one line of credit and have been paying it on time each month, you will definitely have decent credit starting out.
It is important to note that credit scores are calculated differently depending on each person’s unique financial situation. Even if you pay your bills on time every month, you may have a lower starting credit score than a peer who, say, has less student loan debt on their record than you do. You will also usually have a lower credit score to start out with than older borrowers since they have had more time to build positive credit.
Factors affecting your credit score
A good credit score is a must for new loan/credit card borrowers. Hence it is important that we know the major factors that affect the credit score. Some of the factors that affect the credit score of an individual are mentioned below:
1. Credit Utilization Ratio
Whenever you receive a credit card, it has a credit limit. Your credit utilization ratio is worked out on the basis of the amount you use within that limit. For example, if you have Rs 1 lakh. I have a credit limit of Rs.60,000 it. If you use it, then your ratio is 60%. This shows your dependence on credit. A higher credit utilization ratio also indicates an increased payment burden which has a negative impact on your credit score. A low credit utilization ratio (30% or less) indicates higher loan eligibility.
2. Loan Inquiry / Application
Whenever you apply for a loan, the bank or loan institution applies to get your credit report from the credit bureaus, this is known as a hard inquiry. The number of times you have had a hard inquiry is recorded in your credit report and this has a negative impact on your credit score.
3. Payment Records
Your credit score is affected by your loan repayment records such as EMI and credit card bills. Non-payment of credit card bills and non-payment of EMIs on time can have a negative impact on your credit score.
4. Credit Mix
A credit mix is a mix of both secured and unsecured credit. This means, your credit mix comes out from how many secured or unsecured loans you take. Having multiple unsecured loans like credit cards and personal loans can have a negative impact on your credit score as it is often indicated as a sign of mismanagement of personal finance. As if you have more secured loans (like auto and home loans) then your credit score is likely to be higher.
5. Frequently increasing the credit card limit
Frequent requests to increase the credit limit on your credit card also increase the number of inquiries which can adversely affect your credit score. It also shows greater dependence on credit to manage your expenses, which shows that you have a higher loan burden and can be interpreted negatively by banks.
6. Lack of Credit History
Your credit behavior, credit utility limits, loan payment records, etc. are used to calculate your credit score. The absence of credit history negatively impacts your credit score. If you have never taken a loan or never had a credit card, it becomes difficult for the bank to decide whether you fall in the low or high-risk category.
7. Incorrect information in the credit report
Many times, due to administrative incompetence of the bank or credit bureau, wrong information comes in your credit report, such as misspelling your name, showing a loan report that you have never taken, etc. If you find any such information in your report, report it to the credit bureaus so that it can be rectified.
Types of Credit That Affect Your Credit Score
Credit is generally classified as secured or unsecured. Examples of secured credit, such as home loans, loans against property, gold loans, etc., require security/guarantee, whereas, unsecured loans such as credit cards and personal loans do not require any security.
Credit mix is all about maintaining a balance between both secured and unsecured loans. This has a positive impact on your credit score and can increase your chances of availing of new credit.
On the other hand, if you have a lot of unsecured loans, it has a negative impact on your credit score. In such cases, banks may see you as a risky borrower.
How to calculate a credit score?
Different credit bureaus such as TransUnion CIBIL, Equifax, Experian, and CRIF Highmark use different scoring models to use credit report data to generate credit scores. These scoring models use a number of factors when building an individual’s credit score. This is why the same person will have different scores in different credit bureaus, even if the credit history is exactly the same. This is only because the credit bureaus have their own unique proprietary algorithm which is used to calculate the credit score of an individual. Some of the major factors such as credit mix, credit history duration, credit utilization ratio, hard inquiries, and loan repayment records affect an individual’s credit score. You can get more information about them by going to the beginning of the article.
Understanding credit scores and credit reports
A credit score is a 3-digit number of your credit history. It ranges between 300 and 900 and reflects the credit behavior of an individual. This 3-digit number effectively represents an individual’s credit history including payment history. Applying for credit cards, loans, etc., a higher credit score generally has a positive impact. Following is the key information included in the report:
- Credit number
- Full details of your loan and credit card accounts including dues and balances
- Late payment and default (if any)
- List of entities that have checked your credit report and the reason for the investigation (new loan / new credit card, etc.)
- Your Personal Details
Note that your credit report does not include information about your savings, investments, payments or utility bills (unlike credit reports in many countries other than India). Every credit information company – TransUnion CIBIL, Equifax, Experian, and CRIF Highmark – generates its reports using different scoring models.
The credit score ranges between 300 and 900. A score closer to 900 is generally considered a good score and enables an individual to secure credit on more favorable terms as it reflects responsible credit behavior. The general credit score limit is given below:
Very Good: 740-799
How to improve your credit score?
Below are some ways to improve your credit score:
Credit mix: Maintain a balance between both secured and unsecured loans. With many unsecured loans like personal loans and credit cards, banks consider you a risky borrower and can lower your credit score.
Timely repayment of the loan amount: Try to clear your dues on time. This reflects responsible credit behavior and the ability to pay.
Frequently checking your credit report for deficiencies: Sometimes due to administrative deficiencies and fraud of data/information, wrong information gets entered in your report. Therefore, it is advised that you keep checking your report from time to time and contact the credit bureaus immediately if you find any wrong information.
Avoid over-application: Don’t apply for a credit card or loan multiple times in a short span of time. This can increase the number of hard inquiries on your credit report and can have a negative impact on your credit score.
Low Credit Utilization Ratio: Reduce your credit utilization. Limit your credit utilization to a maximum of 30% of your available credit limit. Spending more than 30% of the available credit shows your excessive reliance on credit and negatively impacts your credit score.
Credit Limit Increase: If your bank asks you to increase your credit limit then don’t refuse and you can also ask the bank to increase your credit limit yourself. This does not mean that you start spending more or increase your expenses. But instead, it helps in reducing the credit utilization ratio as it increases the available credit limit but keeps the utilization low. This has a positive effect on your credit score.
Don’t settle the date: Avoid settling your date. While this can reduce the burden of debt, it can make you unable to repay your debt and can have a positive impact on your credit score.
How does a credit score affect your eligibility?
A credit score helps banks determine the creditworthiness of an individual and assess the risk of default on payments. In fact, it works as a first impression for the banks. The higher the credit score, the more positive the loan terms are. A credit score affects your ability to secure a personal loan, car loan, home loan, and credit card in the following ways:
Personal Loan: A low credit score can lead to rejection of your loan application, while a high credit score increases the chances of your loan application being reviewed and approved. A higher credit score can lead to personal security credit with higher terms like lower interest rates, higher amounts, or longer-term tenure.
Car Loan: Individuals with higher credit scores can get loans with lower interest rates and get a new car loan at 0% financing. A low credit score can also affect the payment amount as individuals with a low credit score may be required to pay the payment amount this also exposes the banks to greater risk.
Home Loan: A good credit score increases your chances of securing a home loan and enables you to negotiate better terms and conditions.
Credit Cards: Higher credit score increases your chances of getting more credit, you can avail yourself of higher credit limits and get credit cards with better rewards and benefits. Those with higher credit scores can also get credit cards with lower rates of interest and favorable terms.
Why should you maintain a good credit score?
Though credit score is not the only thing that banks consider while lending money to an individual, it is certainly important that banks look for it while evaluating loan applications. There are many benefits to maintaining a good credit score. Some of them are given below:
A good credit score increases the chances of your loan application being approved, as a higher credit score indicates good loan behavior, higher loan eligibility, and less risk to the bank
- Quick and easy loan approval
- Pre-approved loan
- With a good credit score, you can get a loan at low-interest rates.
- Get credit cards with better rewards and benefits
- Get a higher credit card limit
- Waiver of processing fee and other charges