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All about CIBIL scores and how they affect your interest rates


All about CIBIL scores and how they affect your interest rates

  • By Saral Credit
  • April 11, 2021

Are CIBIL scores esoteric? The answer is both yes and no.

Yes, because despite existence for over 2 decades (the bureau was set up in 2000) and has over 600 million individuals’ and 32 million business records, a larger population of those even present on the bureau record do not understand anything about this three figure numerical expression about their credibility. Not only do they have a challenge on the broad understanding of the score but the concern is about not having to understand their importance and the impact that these scores can have on their financial lives.

No, because it is fairly simple to understand these scores. Notwithstanding the fact that the algorithms applied to arrive at these scores are complex, but one can for sure get insights into the broad requirements and factors that influence them.

To give better clarity to both sets of people (with and without much understanding on the credit scores), I am segmenting this post into three categories.

  1. Interpreting the score range
  2. Factors impacting the scores
  3. How the scores impact the interest rates

Interpreting the Score Range

Score Range of 300 - 900

Each individual is assigned a score between the range of 300 to 900. The accessibility to credit from formal banks and lending institutions gets impacted by these numbers. A higher score denotes to better credit risk profile. The risk profile becomes increasingly higher with diminution of the scores.  

The following illustration will give you a quick idea on how the scores are perceived in relation to your credibility with the lending institutions.

Following are the key highlights of the above illustration:

  • 80% of disbursed unsecured loans have a score of over 750
  • 80% of disbursed secured loans have a score of over 700
  • The secured loans since are backed by a collateral that can be used by the lending institution to recover the dues in case of a default may get approved even with a marginally lower risk profile
  • The chances of getting a loan approval diminish as the score decreases

Any query on the threshold of a good credit score will generally get responded to with an answer of 750. It means that if someone is looking at deriving benefit, both in terms of availability and cost of credit, one must have a score equal to or greater than 750.

Score Range of 1 – 5

There is a different score range for all those who have a credit history of less than 6 months. A higher number will reflect a better credit profile.

Credit Bureaus In India

Before we move on to the next segment, would like to touch upon this important information. Following four bureaus operate in India

  1. CIBIL TransUnion
  2. Equifax
  3. Experian
  4. Crif Highmark

The question may arise that why do we need these many bureaus when just one or two would have been enough to give lending institutions the tooth to deal with defaulters. First, not process can be monopolistic, and second, these are the largest bureaus and their presence in India is just logical.

Factors Impacting Your Credit  Score

Let me now briefly explain to you the factors that impact the credit score. This will definitely facilitate you in having an understanding of what goes into the calculation of this numerical expression of your credit profile.

FICO score calculation is one of the leading score calculation processes and is being used by a large  number of credit bureaus. The following illustration will help you understand the five broad parameters that are used by FICO to calculate the credit score for any individual.

Following are the key highlights of the above illustration:

  • Repayment of existing trade lines carry the highest weightage in ascertaining the credibility
  • Outstanding loan amounts and your payments hold the key since they account for 65% of the calculations. So you would need to be responsible towards the exposure that you would have and timely payments of all the tradelines without any exception

CIBIL TransUnion has given a new definition to these parameters and as per an article published by the bureau’s official the score calculation is as follows:

Following are the key highlights of the above illustration:

  • Past Performance is nothing else but historic payment patterns which can be termed as repayment
  • Credit Exposure seems to be the new term for the amounts owed to various lending institutions at the time of score calculation
  • Credit Type and Duration seems to be a combination of credit mix and length of credit history
  • Practically, the factors considered by FICO and CIBIL TransUnion seem to be similar

So one can conclude that to have a good credit score:

  • One needs to avail only the amount of loan (including the spending on credit cards) that can be repaid without much strain
  • One would need to take into account the untimely expenses that can crop up and must factor that into monthly income before arriving at the amount that can be spared to meet the servicing of monthly installments. The banks generally peg it at 50% of the monthly income

How Credit Scores Impact The Interest Rates

I would like to explain this complex phenomenon with much simplicity by covering it in two parts.

First, the banking business itself. Banking is a complicated and risky business. But it still can be defined as the model that borrows money at a lower price point and further lends it at a higher price point. The margins between the two ends of the spectrum are used to meet both expenses and profits. The banks or any lending institution cannot afford non-repayment from the borrower. So all lenders would want to extend loans or any other credit facility to better paymasters.

Second, we live in a hyper competitive world today. While one may not realize it, the fact is that even banks have competition. Each one of them would want to have a good repayment master on their books. End of the day, it is through the lending products’ repayment that the banks make money.

Considering both the above points, one thing that becomes crystal clear is that the banks would want to have a better customer base. And to assess this nothing can be better than the credit score. So a prospective borrower with a higher credit score (deemed to be a better paymaster) can be offered a lower rate of interest. Since the underwriting of any loan is about mitigating the risk, the borrower with higher risk is bound to get charged a higher interest rate in comparison to one with lower risk.

Let us understand this better through an example.

Two of your knowns approach you for some financial assistance. One of them is placed at a senior position while the other one is struggling with consecutive job losses over the last couple of years. Considering that you do have money to support both of them, but who is the one whom you would be willing to extend a loan to?

Does this question really needs to be answered? While it may not, what if you were to consider lending to both. The latter since would not qualify your comfort parameter for getting repaid in time, you may want to safeguard by asking few others if you should extend money or you may want to keep some collateral to safeguard your hard earned money.

The same is the case with the lending institutions as well.

The banks reward the individuals through a better rate of interest and keep them motivated to continue their repayment streak impeccable. Goes without saying that even a small difference in the interest rates can make a huge difference in the cost of funds and can result in savings of lakhs of rupees in interest alone. 

Conclusion

Credit Scores are a fact of life and our financial life gets grossly impacted with this three number expression. One’s capability to raise funds at the time of need and at a competitive price is based on these scores. Therefore it is imperative for one and all to be as careful about the credit health as one would be about the physical wellbeing.

https://www.ndtv.com/business/how-is-your-cibil-score-calculated-773854