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Understanding the role and importance of credit score.

With the lending scenario having become stringent over the past few years, banks and other financial institutions when reviewing a loan application make sure they have certain checks in place prior to taking a decision on whether to extend credit or decline the request. This is because ultimately a lender takes a risk by offering a loan, and from their perspective it becomes important to know how likely the borrower is to default, or not repay the loan.

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Further, the country’s apex bank, the Reserve Bank of India (RBI) has now made it mandatory for all financial institutions to become members with the four credit bureaus in India, namely CIBIL, Equifax, Experian and CRIF High Mark. It is these credit information bureaus that generate credit reports. The stress on credit information is further emphasised by the fact that a single player in the market has been joined by others, clearly denoting a requirement for the products and services offered by these institutions today.

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One of the first and most important checks the lender does is to pull a copy of the applicant’s credit report, which is a detailed analysis of their credit behaviour, both past as well as present. Derived from this data is the credit score, which is a three-digit numeric representation of the report, typically ranging between 300 and 900.

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What constitutes a credit score?

A credit score takes into account several factors, each with varying weightage.

Length of payment or credit history

Amounts owed or outstanding

Mix of both secured (such as home or auto loans) and unsecured (such as credit cards or personal loans) products in your portfolio

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Credit limit utilisation on your credit card(s)

Multiple enquiries or applications for fresh credit

Importance of credit score for a lender

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The score tells a lender about your creditworthiness, i.e. both the ability and willingness of a borrower to repay a loan they have availed of. Higher the score better are the chances of your application being reviewed favourably. Once the loan is approved, a higher score is more likely to get you the loan at the most competitive interest rates and other terms and conditions. A low score on the other hand triggers a red flag for a lender, because someone with a score below 500 is likely to be insolvent, or at the very least unable to handle credit well. In such cases a lender would not want to extend fresh credit facilities, because the chances of repayment look dim.

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What you do need to keep in mind is that lenders do not review a credit score in isolation and that they assess an application in totality and take into account other factors such as income, expenses and any other fixed commitments you may already have. That said though, a credit score still plays a very crucial role in the process as it is the first things lenders take into account and it therefore becomes important to maintain a good score and understand how to increase credit score over the long run.

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Indeed, a loan for low CIBIL defaulters is available depending upon each lender, but remember that it will never be at the terms that a loan for someone with a good score would be at.

How do you increase credit score?

It is important to not just track your score, but make sure you take the right steps to maintain it as well as going forward, increase the score as well. Here is what you need to do:

Ensure timely bill payment, and ideally in full

Avoid applying for loans and credit cards unnecessarily, however tempting the offers are

Have a healthy mix of both secured and unsecured loan products

When you close a loan, do check that your credit reports reflect the same, and that there is no discrepancy

Importance of CIBIL score for an individual

While the CIBIL score is considered crucial for a lender, it also plays a significant role in each of our financial lives. Here is what all you can expect to gain out of regularly monitoring your score:

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Helps you keep track of your credit behaviour

Easier to identify and rectify instances of identity theft

Inculcate financial discipline in self

Steer clear of debt trap, as you have a good understanding of your credit behaviour

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Helps you save money over the long term, when you get a loan or credit card at the most competitive interest rate and other terms

In conclusion

It pays to be credit healthy, so ensure that your credit report is clean at all times, and that the role and importance of the same is never undermined.