Ultimate Guide to Understand Credit Score
In today’s world, where financial decisions play a pivotal role, understanding credit scores is more important than ever. Whether you’re applying for a loan or seeking a mortgage, your credit score can significantly impact your opportunities and financial well-being. It’s the numerical representation of your creditworthiness, and its significance extends beyond just borrowing money.
Understanding credit scores is not just about boosting your chances of securing favourable interest rates; it’s about empowering yourself with the knowledge to make informed financial decisions.
What is a Credit Score?
A credit score is a three-digit number ranging from 300 to 900 that indicates credit worthiness. The higher your credit score, the better your chances of securing a loan or credit from potential lenders. A credit score above 700 is usually considered good, demonstrating mature credit handling and repayment behaviour.
Types of Credit Scores
There are mainly two types of credit scores, as follows:
Personal Credit Score
A personal credit score indicates an individual's financial credibility. It is based on personal payment history, amounts owed, length of credit history, and new credit. A lower personal credit score indicates risky financial habits and hampers the individual's chances of getting more significant loan amounts or favourable repayment terms.
Business Credit Score
A business credit score signifies a company's creditworthiness. It indicates how well or otherwise the company handles its credits and loans. It is calculated based on the business's repayment history, old and new lines of credit, and collections and liens in the past 7 years. Your business credit score can impact your business loan approval, interest rates, repayment terms, and insurance rates.
While personal and business credit scores are typically separate and independent from each other, there is an exception that applies to small businesses with unlimited liability. In such cases, the creditworthiness or financial health of the company may be evaluated by considering both the business credit score and the personal credit scores of the business owners or partners. This exception highlights that personal credit can indeed influence credit assessment for small businesses with unlimited liability.
How Is Credit Score Calculated?
India has four RBI-licensed bureaus that manage credit histories and assign credit scores to consumers. Each has a unique scoring model, which may lead to a slight difference in scores across the four bureaus. However, a few key factors go into credit score calculation. These are:
Payment History
Your payment history is critical in calculating credit scores since it is one of the important indicator of your financial habits. Payment history includes data on delayed or missed payments, delinquencies, and bankruptcies. Most lenders rely on payment history to predict whether you will repay your debts consistently and on time. Paying your outstanding bills, credit card debts, and loan EMIs on time is crucial in managing your payment history.
Credit Utilisation Ratio
Credit utilisation ratio or credit exposure is the ratio of credit used to the total credit available. Ideally, you should limit your spending to 30% of your credit card limit. High credit exposure could mean you are credit-hungry or struggling financially and, therefore, a risky borrower.
Length of Credit History
Credit history duration refers to the number of years you have been using credit. A long credit history means you have more experience in handling credit. Banks and NFBCs look for longer credit histories as they enable them to accurately assess the borrower's track record and the risk involved in lending.
Credit Type
A mix of short-term, long-term, secured, and unsecured loans in your credit account increases your credit score, indicating that you have experience handling all types of loans.
Credit Inquiries
A hard inquiry is a credit check that impacts your credit score. It occurs when you apply for credit, and a lender or financial institution checks your credit report as part of the application process for credit. A soft inquiry is a credit check that doesn’t affect your credit score and is not visible to lenders, often used for informational purposes. Multiple hard inquiries in a short period may indicate a higher credit risk and may lower your credit score. Limiting unnecessary credit applications is critical. Soft inquiries have no impact on your score.
Why Does Credit Score Matter?
Your credit score matters because it reflects how risky or reliable you are as a borrower. Lenders use your credit score to decide if you are eligible for a loan and assess the potential risk in lending to you.
A high credit score can fetch more significant loan amounts, higher chances of loan approval, better interest rates, and favourable repayment terms. Furthermore, higher credit scores increase your eligibility for unsecured loans.
How to Check Credit Score?
You can download your personal credit report or business credit report from the websites of any of the four RBI licensed credit bureaus in India. You can also get your credit score from online websites with tie-ups with these credit bureaus.
You can get your CRIF Score from the CRIF High Mark website in a few easy steps, including filling in your details, verifying, and authenticating.
How to Improve Credit Score?
Fundamentally, you can maintain a good credit score simply by making your payments on time and not defaulting on EMIs and credit card debts. However, you need a more focused approach if you wish to improve your existing scores. Here are some practical tips to improve your credit score:
Manage Your Payment History
Although it sounds simplistic, repaying your credit card dues, loan EMIs, and all outstanding debts on time is crucial in maintaining a consistently high credit score. Managing your payment history is key to improving your score.
Some ways to manage your payment history are:
Set up payment alerts and reminders on your computer or phone.
Automate your payments through your bank whenever possible.
If you have cash flow issues, prioritise your payments and pay the ones that impact you the most, such as business-critical bills, mortgages, and loans. Remember that all delinquencies are not the same. Individual lenders’ policies can differ, and it is advisable to consult the specific terms and conditions stated in each loan or credit card agreement.
Reduce Credit Utilisation
Low credit exposure assures potential lenders that you are financially responsible. According to experts, you should use your credit card regularly to optimise your credit score but keep your credit utilisation ratio below 30%. Here are a few pointers to reduce your credit utilisation ratio:
Pay off your dues more than once through the billing cycle.
Request your bank for a higher credit limit so that your usage accounts for a lower percentage of the available credit.
Spread your expenses over multiple credit cards to avoid maxing out on one.
Avoid closing your old credit cards so that you have a longer average credit age.
Keep Old Credit Accounts Open
When you close long-standing accounts, you lose out on the length of your credit history, which may result in losing valuable points on your credit score. Keeping older credit accounts open showcases your financial stability and competence in handling credit.
Diversify Your Credit Types
A healthy mix of credit types, such as credit cards, mortgages, and different kinds of loans, can positively impact your credit score. The fact that you can efficiently manage various credit accounts showcases your competence and helps build a comprehensive credit profile.
Avoid Hard Inquiries
A soft inquiry is when you get your credit report but do not apply for new credit. A hard inquiry is generated when lenders or creditors pull your credit report with your authorisation as part of a loan or credit application process. While a soft inquiry does not impact your credit score, a hard inquiry can reduce your credit score by a few points.
If you are trying to build a positive credit history, you should minimise the occasions for hard inquiry by limiting new credit lines or loan applications.
Monitor Your Credit Reports
Besides building a positive credit history, it is also vital to maintain a good credit score. One way to do it is to monitor your credit reports periodically for errors and inconsistencies, which can substantially diminish your score.
In case of any inaccuracies, you should promptly raise a dispute with the credit bureau and have them rectified.
Some Common Credit Score Myths Busted
People invariably fall prey to myths and rumours when it comes to credit scores. It is crucial to have accurate information about credit score since they shape your financial profile. Here are some common credit score myths debunked:
Checking your own credit can hurt your credit score
Checking your credit score, whether or not you are applying for new credit, is considered a soft inquiry that does not impact your credit score. In fact, keeping an eye on your score can help you spot areas of improvement in your financial behaviour.
Opening several accounts will improve your credit score
Opening several accounts does not improve your credit score. On the contrary, lenders may see you as a credit-hungry and high-risk borrower if you have too many accounts.
Closing old accounts will boost credit score
As discussed before, the length of credit history is an important factor. Closing old accounts shortens your credit history, possibly negatively impact your credit score.
Disputing credit report information can increase credit score
All disputes do not raise your credit score. You can raise a dispute for errors in your personal, business, or bank account details or inaccuracies in transaction data. If verified, these details will be rectified, bringing your credit history on track. However, for issues with transactions and bank accounts, the credit bureau will contact the lender for further information. If the lender denies the changes and you cannot authenticate your claims, the credit bureau will reject your application. In this case, your credit score will not change.
You cannot get a loan with a bad credit score
This is a fallacy. Some lenders do provide bad credit loans or title loans to entities with bad or no credit. However, these are secured loans against collateral such as property, gold, or a vehicle with higher interest rates.
Conclusion
A credit score is a metric that determines an individual's or business's eligibility for a loan or new credit. Maintaining a good credit score is crucial because it impacts your interest rates and repayment terms when you apply for a loan. The best way to maintain a high credit score is to pay your debts and EMIs on time and limit your credit exposure to 30% of your card limit. However, do not despair if you have a low credit score. It is possible to build your score over time by following a few best practices, such as timely payments, managing delinquencies, and diversifying your credit types.
It is also possible to get a secured loan with a bad credit score, although at higher interest rates. If managed well, it will eventually help to increase your score.
Your credit score is thus an indication of your financial health. With an optimal score, you reap multiple financial benefits. If your score is suboptimal, you must find ways to improve it.