How Does Your Credit Score Affect your Interest Rates?

Newspapers, bank websites, SMS and even ads at you see on YouTube are full advertisements on low-interest rates on various kinds of credit products right from home loans to auto loans, etc. Quite often you must have even thought that the rates of interest advertised are too good to be true. You must have also got tempted and looked at purchasing because the interest rates looked very attractive.

But these are the best rates that are on offer by the bank for those customers who meet all their criteria like a good credit score, specified amount of income, etc. Among all the factors that affect the interest rate on a loan, credit score plays a very important part of late. Before Credit Information Companies started assessing individuals on various parameters of their credit behavior and started assigning them credit scores, the banks had no knowledge of slip-ups in credit behavior on the part of the customer if they had been committed at other branches or banks.

Hence, a standard pricing of loans were followed in which all customers, whether creditworthy or unworthy, paid the same rate of interest. However, we have moved on from those days and today the pricing of interest rate on loans is done much differently.

Let's see how!

What is the Relation Between Your Credit Score And The Rate Of Interest?

Lending is a risky business for anyone. Think about it! Would you be fine with lending even a small sum of money to a neighbor or a friend who is known for his habit of not returning the money? Probably not, right? Similarly, a customer is a total stranger to a bank. Before lending any sum of money, the bank would like to ascertain the probability of the amount being repaid on time.

The only way that a lender can ascertain this is through a credit score.

A Credit Score is nothing but a numerical representation of your past credit behavior shown in the range of 300-900, with higher scores denoting better standards of creditworthiness.

A credit score and the parameters that make it up are carefully analyzed before taking a decision to lend by the banks/ financial institutions. This gives them a good insight into the expected credit behavior of the applicant in future. Based on this information, the lenders set an interest rate.

If an individual demonstrates through his or her credit score that he/ she is a creditworthy customer, then the lending institution understands that the individual does not present a big risk in lending and can price the loan at a lower component of risk, i.e. interest.

Lower pricing of the loan is done provided all other factors required for approving a loan, like income commensurates with the loan applied for, stable employment, satisfactory portion of the income left for debt repayment, etc.

Are Lenders Already Pricing Their Loans According To The Credit Score Of The Applicants?

The awareness and utilization of the credit score has picked up of late. While theoretically, it sounds right that loans are priced according to the risk involved in lending, we understand that you might have questions on whether the same is being followed by lenders?

Yes! We bring to you examples of interest charged by different banks on various credit products based on credit scores.

* Risk Grade as assessed by the bank

Additional Reading: How bad is your credit score?

What are the Other Factors Pertaining to a Loan That Can Be Affected By Your Credit Score?

While your credit score plays a big role in determining your rate of interest, which is a deal breaker in deciding any loan, it also bears an impact on other aspects of a loan which could be:

Down Payment: Most of the loans require a down payment which is also considered as a commitment from the borrowers end towards the loan. With a low credit score, the lender may end up reducing the loan to value ratio or in other words, demand a higher figure of down payment. This may end up being a drain on the finances.

Tenure of the Loan: For loans like home loans which are big-ticket loans, tenures generally tend to be extended. For an individual with a low credit score, the lender may insist on approving the loan for a shorter tenure which then increases the EMI amount.

Amount of the Loan: The total amount of the loan approved may itself be reduced for an individual with a low credit score, which may turn out to be a cause of mental distress to the individual who is in urgent need of funds.

There are a lot of associated factors with a bad credit score; you might want to read more on the negative effects of a bad credit score here.

End Note

The only good thing about a bad credit score is that it doesn't stay bad forever. You can always take efforts toward improving your credit score; some simple things like paying your bills and EMIs on time, keeping your credit utilization low or limiting your applications to credit always help.