Lending is a risky business for banks and other financial institutions. The risk of default or delayed repayment is one of the main risks involved in any kind of lending.
If you notice, you would not like to lend money or any of your personal belongings to a complete stranger as you have no guarantee over if your money or belongings will be returned or taken care of in the right manner.
Even if banks and financial institutions are in the business of lending and borrowing, it is also hard for them to just lend to a customer who might be a complete stranger to the bank. To help them assess risk involved in lending to a customer, a metric is being put in place. This is nothing but the Credit Score.
What is a Credit Score?
A credit score is the measure of an individual's creditworthiness. It is denoted by numbers in the range of 300-900, with higher scores indicating higher levels of creditworthiness.
Creditworthiness is gauged on the basis of past credit behavior. It is construed that if an individual has been responsible with credit earlier and has made prompt repayments, they are more likely to do so in future as well.
Additional Reading: Can I get a loan with a credit score of 700?
How is a Credit Score Calculated?
When we talk about past credit behavior, there are many actions pertaining to credit. Is it only repayments that count towards your credit score? No.
Each and every action pertaining to credit availed by you plays a part in deciding your credit score. All actions right from your application for credit, to its approval or rejection, promptness of repayments, the number of credit accounts held by you, how much of your credit limit is being used and the manner in which you close your credit accounts - all of this goes into your credit score as inputs.
The main factors that decide your credit score are:
Your Credit Accounts: The number of loan and credit card accounts under your PAN and if they are considered positive or negative accounts
Repayments on your Credit Accounts: Prompt repayments on your loan and credit card accounts is one of the cornerstones of a credit score
Credit Mix: A good balance of secured and unsecured accounts is what the lenders look for
Credit History: Individuals with long history of handling credit responsibly earn brownie points for their credit score. Those who are new to credit will need to build it up slowly and steadily
Credit Utilisation Ratio: This is calculated by dividing your spending on credit card by the overall credit limit. The ratio of utilization to your credit limit should not exceed the prescribed limit of 30%. This demonstrates that you do not live off credit
Number of Hard inquiries: Each application for credit is considered a hard inquiry. The more frequently you apply to credit, the lower your score can go
Who Calculates Your Credit Score?
Your lender is the focal point where all data pertaining to your credit score is generated. At pre-determined intervals (generally after month end), all the actions (application, disbursal, repayment, closure, etc.) pertaining to a PAN number is sent to Credit Information Service Provider or Credit Bureaus, as they are popularly known as.
Additional Reading: Learn more about Credit Bureaus in India
Each of the information is given weight as per the Credit Score formula/ algorithm followed by each of the credit bureaus, and then your credit score is formulated. So, it is possible that your credit score varies with the credit bureaus. However, unless there is a huge variance, it should not bother you.
Whenever you submit an application for any credit product, i.e. a credit card or a loan, the lender pulls out the credit report pertaining to your PAN card and check for your score and view the report before basing the decision to do further due diligence of your application with regards to income and other criteria.
There are no credit decisions made without assessing the credit score, hence it has become imperative to have a good credit score.
How Can You Build Your Credit Score?
Now that you know the basics of your credit score, we can move on to see how one can build their credit score and be credit healthy at all times.
Maintain Positive Credit Accounts: It is important to maintain all your credit accounts in the positive status at all times. Being in the positive status would mean that the concerned credit account is being repaid by the customer at pre-determined intervals. If you stop repayments on a particular credit account, it will be considered as a negative credit account and will drag your score down.
Prompt Repayments: Repayments is one of the main factors that can help you build a good credit score. All repayments on your loans and credit card outstanding bills should be cleared on or before the due date. If you are under any kind of financial distress and are not able to pay a particular installment, it is good to take your lender under confidence beforehand.
Maintain a good mix of secured and unsecured credit: Secured credit is the credit that is backed by an asset, such as a home loan, vehicle loan or gold loan. On the other hand, credit cards and personal loans are unsecured borrowings and are not backed by an asset. A good borrower is expected to have a judicious mix of both kinds of borrowing. If you have just unsecured borrowings in your portfolio, then it might be construed that you have been borrowing just for spending and not creating assets.
To ensure a good credit score, it is good to have a decent mix of secured and unsecured borrowing.
Do not overuse your credit card: Every credit card comes with the maximum amount that can be spent on the card. This is decided based on your credit score and income. However, it is not considered credit healthy to be spending the entire amount during each of your billing cycle. Ideally, you should not utilize more than 30% of your credit limit.
Longer periods of creditworthiness: Longer periods of responsible behavior towards credit is a great factor which can help you build good credit score. On the other hand, those with shorter periods of dealing with credit may see a lower credit score. Therefore, before closing any of your older credit accounts, make sure to pay attention to the fact that it may impact your credit score.
Additional Reading: How Long Does It Take To Improve Your Credit Score?
Do not apply for credit frequently: One should ideally apply for credit only when there is a genuine need for it. Every application for credit is considered as a hard inquiry and more the number of hard inquiries, lower will be your credit score. An individual who applies for credit frequently is considered as a credit hungry person and hence, will see their score dipping.
By following these basics, you can see that your credit score become better. However, you would need to also bear in mind that credit scores cannot improve overnight. It takes a sustained period of being responsibly towards credit to see your credit scores move higher.