September 14, 2024 · 12 mins read
Santosh Kumar
A credit score is a three-digit number ranging from 300 to 850 that determines an individual's creditworthiness. As long as an individual has a higher credit score, they may get approved for loans at better rates. A credit score is mainly based on a person's credit history, including the number of accounts, levels of debt, repayment history, etc. Lenders use a credit score to evaluate creditworthiness and ensure loan repayment. How is credit score calculated and all the details necessary to understand credit score is further explained below.
Credit score models are tools designed to assess creditworthiness. Credit bureaus and lenders use these models to evaluate the risk associated with credit. These models evaluate credit based on factors like payment history, credit utilization, credit accounts, etc. A high credit score indicates lower default risk, which leads to favourable terms for loans, and a lower credit score leads to high interest rates.
Credit scores and reports play a significant role in helping financial institutions determine credit lending risks. They help lenders determine the risk in case the borrower does not repay. Borrowers can take advantage of the offers associated with a good credit score and are seen as less risky for lenders. However, a lower score will cost more money and increase monthly payments in the long run.
A higher credit score will be viewed as favourable by lenders, which, in turn, lowers interest rates. While lender set their own credit score range and credit criteria for lending, credit scores of more than 800 are considered excellent. The general categorization for credit scores are:
1. Excellent: 800-850: Low risk borrowers, easy to secure loan.
2. Very Good: 740-799: Good credit history and easy-to-get credit application.
3. Good: 739-670: Can get credit and loan applications with scope for improvement.
4. Fair: 669-580: There is a high risk of default, and it is hard to qualify for new credit.
5. Poor: 579-300: Greater chance of credit rejection.
The benefits of having a good score are:
A high credit score allows borrowers to take advantage of low interest rates on loans, which enables higher savings.
Every lender has its own lending criteria and offers the type of loan according to the "cut-off" it has set. A lender may segment fixed rates and provide the most favourable interest rates to borrowers with high credit scores.
Credit card issuers use credit score cut-offs to determine whether or not the person qualifies for a credit card. Credit card issuers also leverage credit scores to market their products. Not all cards with a good score guarantee rewards or offers; credit card issuers also consider income and other debts before making offers.
Service companies may check credit reports and accounts to assess the risk of taking a customer. A customer with a bad credit history may require a large down payment before starting service.
Read More: How to File a Complaint for Your CIBIL Score
How is credit score calculated is a common question asked by people who wish to improve their credit score or apply for credit. A credit score is mainly determined by 5 key elements: payment history, the amount owed, length of credit history, types of credit and new credit.
The main elements considered while calculating credit scores are:
1. Payment history (35%)
2. Amounts owed (30%)
3. Length of credit history (15%)
4. Types of credit (10%)
5. New credit (10%)
1. Payment history: payment history includes all details on payment of financial obligations. It records every time there was a delayed payment and the severity of those delays.
2. Amounts owed: Amount owed refers to the percentage of credit used compared to the availability of credit, known as credit utilization.
3. Length of credit history: a longer history of credit is perceived as less risky because of the increased amount of information available to asses payment reliability
4. Types of credit: The lender can understand that different types of credit, such as car loans, mortgage loans, and revolving credit, can be managed.
5. New credit: Many credit applications in a short period can be seen as a sign of financial urgency, which can have an adverse effect on credit scores.
Read More: Top Factors that Affect Your CIBIL Score
1. Hard and soft inquiries: Lenders find out about credit history and other related information of the borrower when they apply for loan or credit which is called a hard inquiry. A soft inquiry is done while checking for credit score or when there is ore approved loan or credit card offer inquiries. Soft inquiries do not impact credit score.
2. Increase in credit limit: A good credit behavior and score will allow lenders to increase the credit limit. Accepting such offers will enable a significant increase in the credit ratio and helps lower the credit utilization ratio which in turn will have a positive impact on the credit score.
3. Opening new credit accounts frequently: Opening credit accounts frequently means it is not enough to have existing accounts to fulfil requirements so there will be a higher credit burden in the future which will bring down the credit score.
4. Credit mix: Having at least one secured loan with a long debt period ( e.g home loans) in the credit mix rather than a number of unsecured loans will be of great advantage in the future.
Read More: Is 720 a Good CIBIL Score?
The criteria and methods for calculating credit score are determined by credit bureaus. Therefore, the question arises how is credit score calculated in India? There are 4 major credit bureaus in India which are CIBIL, Experian, Equifax and CRIF High Mark. All of these credit bureaus have similar factors to determined the credit score but have their own methods to calculate it.
Vantage Score is a type of credit rating designed for consumers by the Equifax, Experian and TransUnion credit bureaus as a different option from the credit score. The score generates a unique score for each of the 3 credit bureaus specific to the information from that bureau.
The credit score is technically 3, with slight differences due to each bureau's different calculation techniques. On the other hand, a Vantage Score is a unified score that includes data from all 3 credit bureaus and is utilized by each in the same manner.
Read More: What is the Use of CIBIL Score?
To quickly improve your credit score, enrol in services that add payment information like rent, utility bills, etc., which are not included in the credit score. If there is a good track record and bills are paid on time, a service like Experian Boost could help quickly increase the credit score.
Credit reports will include different types of financial information, from new credit to bankruptcies. There is no time limit for positive information to stay in the report. However, negative information must be removed. Some of the major events that appear in credit reports are:
1. New credit: A "hard inquiry" is done when a new credit application stays on the report for up to 2 years. Multiple applications for new credit can increase the risk as it indicates the borrower’s urgency of money.
2. Late payments: Creditors wait for up to 180 days of missed or delayed payments before charging off debt. A charge-off may take at least 6 months to appear in the report. When it does appear, it can stay for up to 7 years from the end of the 180 days.
3. On-time payments: Payments made close to the time the creditor reports are shown immediately in the reports. If the creditor reports it directly after the payment is recorded, then it shows up after a month.
4. Bankruptcy: It is a kind of negative information that stays in the reports for up to 7 - 10 years. Bankruptcy is an indicator that repayment is not made on time, which can further lower the credit score. Bankruptcies are the longest financial event that stays on the credit report as they appear for up to 10 years.
Read More: How Credit Card Usage Makes or Breaks Your Credit Score?
1. Ignoring credit: Checking credit is crucial for monitoring and maintaining a good credit score, tracking progress, and identifying potential damage. Look for items in the credit report that have the potential to damage your credit score and address them immediately.
2. No on-time payments: Payment history is the most vital factor in maintaining a good credit score. Missing even a single payment can adversely affect the credit score and remain on the credit report for seven years.
3. Making only minimum payments: Minimum payments will increase interest charges, and an increased balance can damage credit score and increase the percentage of available credit.
4. Applying for multiple credit cards at once: A hard inquiry is done during a new credit application, which will display the need for desperate money, which can have a negative effect on the credit score, lowering the credit score
5. Taking on unnecessary credit: Taking out personal loans for recreational purposes will increase debt and risk of late payment. Avoid paying interest charges unnecessarily by applying for credit only when necessary.
6. Closing credit card accounts: Closing credit card accounts can remain in the history of credit reports for up to 10 years. However, cancelling available credit immediately can cause the credit utilization rate to increase.
7. Selecting longer auto loan terms: Long auto loan terms can reduce monthly payments. However, they can have unintended consequences, negatively impacting credit scores and resulting in higher interest payments over the life of the loan.
8. Becoming complacent: Maintaining finances, actively saving, paying off debt, etc., are ways to improve money management. However, a higher income is complacency, which can lead to negative trends in finances.
Read More: How Students with No Income Can Get a Credit Card
Monitoring credit is vital to ensure that credit scoring is done according to the parameters set by the credit authorities. Credit management is crucial in collecting loans as per the set policies.
Some ways to monitor credit scores are:
1. Soft credit checks: This allows you to check credit scores without having an impact on them, as opposed to hard credit checks, which can lower the credit score.
2. Free annual credit report: Some authorities offer a free credit report once a year, which allows the examination of the reports and finding errors or incorrect details. However, reporting any such discrepancies can have a negative impact on the credit score.
3. Careful review of credit card bills: It is vital to review monthly credit card statements as there can be unauthorized charges that can appear, which might be identity theft or fraud. Notifying them to the bank or the concerned financial institution can prevent further harm and protect credit limits.
Understanding the factors influencing credit score and how is credit score calculated is vital in establishing and maintaining an excellent credit score. Identifying the elements that have an adverse effect and understanding the cause can help create a strategy to improve credit scores and increase the chances of getting approved for financial products at better rates, leading towards a better financial health.
Read More: CIBIL Score Role in Loan Application Process
What is considered to be a good credit score for applying for any loans?
A credit score of 700-750 is the basic requirement for most of the financial institutions while checking the loan credibility of a person. It is good to check the credit score beforehand while applying for any loan.
What are the factors that affect a person’s credit score?
The most important factor in calculation of a person’s credit score is their loans/credit payments history. Other important elements are age of the person, number of loans and credit cards and usage of the existing credit limit.
How does a credit score affect my loan application?
A good credit score can help you to secure a loan of a higher amount with a lesser interest rate, whereas, if the credit score is not above 700, you might have to pay a higher interest rate for the same amount of loan.
Can a change in my credit score affect an ongoing loan I have?
Any change in a person’s credit score whether good or bad can affect the loan they currently have if they have acquired a loan on a floating rate of interest, if the scores get better with time, he can easily apply for a re-calculation of the rate of interest provided initially.
Does having a low amount of money in my savings account affect my credit score?
The amount of money you have in any savings/current account does not affect the credit score at all as it only takes into consideration, the payments are being made on time for the existing loans or not.
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