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The components of an Individual’s credit score and how it is calculated
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Your application for a home loan has been rejected by the bank? You are a little annoyed because you don’t know why it was rejected as you have never defaulted on any loan repayment, you have always paid your bills on time, and you have submitted all documents — property and income-related — required for securing the loan. Only later, you find out that your application was rejected because of your low credit score. For the uninitiated, a credit score, computed by credit information companies like CIBIL, Experian or Equifax, indicates your credit-worthiness to the lender. Most lenders today rely on credit scores and credit reports while reviewing loan applications and those with higher scores are given preference.
As per data released by CIBIL recently, over 90% of new credit is sanctioned to people with scores of 700 and above. According to CIBIL, the credit score is calculated after taking into account defaults made by the individual, amount of credit being used, number of loan applications, loan mix and so on. Simply put, default on repayment is just one of the factors that determine your credit score. “Borrowers tend to assume that having a clean repayment history alone can ensure a good credit score. However, there are several other factors that can influence the score,” says Rajiv Raj, co-founder and director of creditvidya.com, a credit counselling firm. Of course, repayment history gets the maximum weightage (35%) while computing the scores.
“The second-most important fact is the credit utilisation, which accounts for 30% of the score. That is, how much of your available credit you have utilised. The third factor would be vintage of credit – for how long you have been using credit — which gets a weightage of 15%. The fourth factor is account mix — the composition of the secured and unsecured loans in your credit profile. A good mix of credit is important to have a robust score,” he adds. Do note, however, that the weightage could vary as per the credit information company.
SEEKING AND TAKING TOO MANY LOANS
Even if you are diligent with your EMI (equated monthly installments) payments, the fact that you have obtained multiple loans could work against you. What’s more, merely applying for too many loans could drag your credit score down. “Don’t apply for too many loans or credit cards as this would mean more enquiries are added on your credit report, which negatively impacts your credit score. Simply because, this credit behavior indicates that you are “Credit Hungry” and implies that you are constantly looking for credit,” explains Arun Thukral, managing director, CIBIL. A lot depends on the lender’s perception, too. “If a person has applied for too many loans or credit cards, he or she is seen as someone who is credit-hungry. This may not necessarily be a negative factor, but could be a trigger for banks to be cautious while scrutinising loan applications,” explains Abhijit Bose, head, retail assets and strategic alliances, DCB Bank.
UNFAVOURABLE LOAN-MIX
Lenders, for obvious reasons, see borrowers with a higher share of secured loans as more reliable. “If the individual’s loan portfolio is skewed in favour of unsecured loans, it is viewed with caution by banks as this is a sign of irregular fund flows to the customer resulting into an overleveraged customer,” Manavjeet Singh, senior president, retail banking, YES Bank. Go for secured loans like auto and gold, wherever possible instead of taking the easy way out and swiping your credit card or giving in to calls exhorting you to take a personal loan. It would be wise to have a good mix of all kinds of loans. Rajiv Raj, however, cautions against applying for secured loans simply to boost your score. “Since this is a small component of your score, you needn’t worry if you don’t have accounts in each of these categories. Also, don’t open new accounts just to increase your mix of credit type.”
FREQUENT CLOSURE OF LOAN ACCOUNTS
Now, this may come as a surprise to you, as an average Indian believes in disposing of a liability as soon as possible. However, the fact is that frequent foreclosure of loans can bring down your credit score. “Once you have availed of a loan, it is advisable to keep it for at least 12 months before closing it. The velocity of “opening” and “closing” a loan account impacts your credit score,” says Thukral. If your score goes down due to constant opening and closing of accounts, banks could take a call after understanding the nature of your fund usage.
“Lenders will definitely ask why loans are being taken and repaid so frequently. It is important to ensure that the money is not being invested in stocks or for speculative purposes. Also, the lender would like to see, if the customer is revolving by taking a new loan to repay an existing one, which is not good . However, if the borrower is an entrepreneur borrowing to finance his/her working capital needs, or is engaged in a seasonal business where there is a short-term demand, - it will not be a cause for concern,” explains Bose. Put simply, as long as lenders see a justifiable explanation for the borrowing and repaying pattern, borrowers’ future loan prospects will not be affected.
HIGH UTILISATION OF CREDIT LIMITS
All credit cards come with credit limits, that is, the extent to which the card can fund your expenses. If you are too close to breaching this limit, again, your credit score is bound to suffer. For instance, if you have used . 90,000 out of a credit limit of . 1,00,000, this may affect your credit score. “While increased spending on your credit cards may not necessarily negatively affect your score, an increase in the current balance on the card overtime is an indication of an increased repayment burden and may negatively impact your score. It’s always prudent to not use too much credit,” says Thukral. Raj of Creditvidya-.com reckons that to have a good score, your credit utilisation should be less than 30% of the sanctioned limit.
However, remember, while high utilisation of credit limit may affect your score, it will not necessarily hamper your chances of securing a loan. “Even if it is assumed that credit information companies have information on the individuals card limits, high utilisation of these limits may not be a negative factor as lenders will also take into account your income level and the number of active and in use cards. However,high utilisation coupled with other factors like revolving tendency, high bounce rates, etc will have an adverse impact on your loan applications,” says Bose. After all, if you are not regularly clearing your credit card bills or have been merely paying the minimum amount due, high utilisation of credit limit indicates that you are in a desperate situation.
DEFAULTING ON LOAN REPAYMENTS
This is one factor most borrowers are now familiar with, as it is the primary cause of an unfavourable credit report and a low credit score. “Repayment history has the maximum weightage for score calculation which is pegged at 35%. Here, the recency and severity of default impact the score a lot. And if you have paid late, then how late. For instance, if it is delayed by 30 days, 60 days, over 90 days, etc. The greater the delay, the worse it is for your score. Also, adverse information on your credit report such as a compromise settlement, write-off, post write-off (settled) raise a red flag,” says Raj. The only means of avoiding this taint on your portfolio is to be regular with your repayments.
IMPROVE YOUR CREDIT SCORE
Now that you are aware of the causes, particularly the ones that could pull your credit score down, you can work towards improving it. “It is always better to have a secured debt to ensure good credit score, but in cases where it is not possible, have minimum number of credit cards and personal loan. In case, one is not able to pay the credit card debt due to some compelling reasons, one should approach the banker and request the banker to convert credit card dues into loan repayable in installments instead of defaulting. This will ensure that that the track record improves once the borrower starts paying installments on time. At the same time, he can also save on the interest,” suggests VN Kulkarni, chief credit counsellor with the Bank of India-backed Abhay Credit Counselling Centre.
Apart from maintaining the regular repayment hygiene, you can also take certain additional steps to safeguard your credit score. “Ensure that you monitor your co-signed and joint accounts every month. Similarly, monitor the loan accounts for which you have stood as a ‘guarantor’,” advises Thukral. Finally, checking your credit report at regular intervals will help you alert CIBIL or other credit information companies like Equifax and Experian about errors that may have crept in. “If the lender has committed any mistake in reporting or there is a case of identity theft, one should bring it to the notice of such lender and correct the report. Such timely action will help in improving the score,” adds Kulkarni.
