Creditworthiness is how “worthy” one is of using credit. If a lender believes that the borrower will respect all debt obligations promptly, the borrower is considered being creditworthy. For a borrower to evaluate his/her creditworthiness, it could be challenging and may result in a conflict of interest with the lender. Hence, most credit bureaus assess the individual creditworthiness and associated risk of repayment to help lenders in determining whether to lend to a borrower.
There are many myths associating credit score with creditworthiness. People often find it difficult to validate and apply such myths to real-life credit scenarios. Here, we will try and demystify the fact that credit scores mostly have nothing to do with creditworthiness and also explain the reasons why.
What is Creditworthiness?
Creditworthiness is usually measured through a credit score (that can range between 300 and 900). It is an assessment of the likelihood of a borrower repaying the loan or credit borrowed. Four main credit agencies in India provide credit scores and also detailed credit reports. These are CIBIL™, Experian, Equifax, and CRIF HighMark.
Generally, a higher credit score is considered better by lenders. However, credit scores may be different across different bureaus since each has its own set of credit calculation methodologies. All the credit bureaus are required to provide borrowers with at least one free credit report every year through their respective websites.
While credit scores are often used by lenders to determine a borrower’s capability to repay, it does not necessarily define the borrower’s creditworthiness. This is because a borrower may be capable of repaying a credit or loan, however, he/she may not necessarily be willing to repay all the borrowings.
How are credit scores calculated?
Financial institutions like banks and NBFCs that offer credit to customers periodically share data with credit bureaus. These, in turn, calculate the credit score of borrowers by using proprietary algorithms. Several parameters influence the credit score of a borrower, some of them are as below:
- Repayment history: Has the borrower been making repayments on time or have there been any defaults?
- Credit inquiries: What is the frequency of enquiries related to credit or loans?
- Credit mix: What kind of balance is maintained between secured and unsecured loans? Does the borrower have a lot of outstanding debt?
- Credit utilization: What is the rate of increase in debt over some time? Is the borrower taking on more debt? Is he/she utilizing available credit limits fully?
How do credit scores work?
While a credit score may not necessarily determine a borrower’s creditworthiness, it can have a significant impact on his/her financial life. It plays an important role in a lender's decision to offer credit to the borrower. People who have credit scores below 640 are generally considered risky borrowers. Lending institutions may charge high interest on credit offered to such borrowers. This helps in compensating for carrying the additional risk. They may also provide a shorter repayment term or require a co-signer in the contract.
A credit score of 700 or above is considered good and could result in a borrower getting credit with a lower interest rate. This, in turn, results in less money being paid towards interest over the loan term. Scores beyond 800 are considered excellent. Creditors often define their range for credit scores, however, the average score range used by many is:
- Excellent: 800 to 850
- Very Good: 740 to 799
- Good: 670 to 739
- Fair: 580 to 669
- Poor: 300 to 579
Lenders review borrowers' scores periodically, especially while determining interest rate changes or increasing credit limit on a credit card.
Which other factors influence creditworthiness?
Depending on the lender, there can be various factors other than the credit score that influence the decision criterion for offering a loan. Banks have their internal benchmarks as far as acceptable scores are concerned. They may also utilize additional data for the approval process. For instance, they may check an applicant’s income levels, employment history, bank statements (to determine spending and saving habits), and combine such information with in-house policies and models to further perform credit risk analysis.
Whether it is a credit card application or a housing loan requirement, lenders check the credit score of borrowers to determine their eligibility. Financial institutions use credit ratings to measure and determine whether an applicant is eligible for credit. A higher credit rating indicates a lower risk premium for the lender.
A credit report is much more comprehensive rather than just being a representation of creditworthiness. It provides details of the borrower’s total debt, credit limits, and history of defaults if any.
- How does a credit score indicate creditworthiness?
To judge a borrower’s creditworthiness, lenders take into account the evidence of timely bill repayments and track record of managing past debts. A higher credit score broadly indicates greater creditworthiness.
- Is there any relation between creditworthiness and credit score?
A credit rating indicates the creditworthiness of a borrower. A numerical credit score is often used as an expression of creditworthiness; however, it is not necessarily the only determinant of creditworthiness.
- How can one determine creditworthiness?
Creditworthiness can be determined by looking at a borrower’s credit score. Along with this, the annual income, stability of income, spending habits, etc also contribute to one’s creditworthiness in the long run.
- What factors affect your creditworthiness?
Creditworthiness is determined by factors such as repayment history and credit score. Some lenders also consider the total assets and liabilities of the borrower while determining the probability of default.
- What are the three factors used by lenders to judge creditworthiness?
Creditors generally follow a similar set of principles while evaluating a borrower's creditworthiness. The three commonly used factors are "three Cs": capacity, capital, and character. These help in gauging a borrower’s creditworthiness.