Everyone has friends or acquaintances who boast of insane limits on their credit cards, or having availed a ridiculous amount of loan for getting a lavish house built. Then there are businessmen, contractors, builders and the like whose work depends on lots of financial investment. Even lending a small sum of money to an acquaintance remains as an afterthought. Then have you ever wondered how or why high limits on credit cards and humongous loans are approved by banks?
The answer lies in two words - credit score. Credit scores are the indicators of how valuable a prospective customer can be for a bank. That in itself makes it a very important aspect for banks. Based on a history of credit scores, loans are approved or credit cards are handed out.
Credit Information and Score - The Who’s and How’s
Credit information and scores are maintained and calculated by CICs (Credit Information Companies). These are basically organisations who have been authorised by the Reserve Bank of India (RBI) to collate and analyse business credit information.
Since 2009, as per the Credit Information Companies Act, 2005, the RBI has approved four organisations to operate as credit information companies in India. The oldest and first such company in India is CIBIL (Credit Information Bureau (India) Limited).
CICs typically match up the total available credit limit of any entity (business/individual) with their spendings and savings. The resulting score could be anything between 300 to 900. That is known as the credit score, also known as the CIBIL TransUnion score. The score’s trend for a particular entity over a specific period of time forms the credit information report issued by CIBIL.
Credit History, Credit Information and Credit Score for the New Borrower
It’s not a worthwhile assumption that living a loan-free or credit-free life will basically ensure a credit score that’s exemplary. It may be true for some instances but not all. As a foundation to how the credit score is calculated and the credit history tallied, let’s take a look at the factors affecting credit score -
- Gross Income – I
- Gross Balance in the Bank(s) at the end of the month – B
- Assets declared (movable/immovable) – A
- Available Credit Limit (if using credit cards) – C
- Gross Outstanding (if any) – O
- Loans (if any) – L
- Years of Stable Income – Y
If it is assumed that all factors mentioned above are applicable for an entity, the credit score could be tallied using I, B, A, C as the positive factors and O, L as the factors that have a negative effect. The score observed over a period of Y makes up the credit history.
For a new borrower, factors C, O and L might not be applicable, but the rest are there to stay. This makes tallying the score more aggressive. CICs would make a beeline for the balance in the bank accounts at the end of the month and would keep a close watch on how stable the income has been and for how long.
In other words, if the income (I) has been regular for 2 years or more, and the gross balance (B) at the end of a majority of months has been substantial or gradually incrementing compared to the income per month that adds up to a pristine credit score. If the trend has been in effect for years together, the credit history becomes stellar.
Consequently, major fluctuations in income regularity and low balance at the end of months are indicators of a poor credit score. If the trend follows over a longer period, like 3-4 years or more, the credit history could be marred in a severe way.
As a fresh borrower, if one has great money management skills, the credit score could remain close to the upper levels towards 900. Since most banks in India look for prospective customers who have a credit score of 750 or more, maintaining a healthy financial history becomes all the more important for a fledgling borrower.
Relevance of Credit Score
People already using credit cards or loans are diligent enough to make payments when they are due, to avoid marring their credit scores. It doesn’t matter if one has had multiple credit cards or loans, making informed decisions about paying off their dues in a timely manner is a mandate. Every action a customer takes in spending or repaying affects the score.
It could be argued that credit scores are relevant only when you have an active open line of credit, in the forms of loans or cards. But that is not the case. For people who have not had any financial liabilities whatsoever, their credit score is also calculated and maintained. Credit score takes into account everything that deals with how one manages his/her funds.
So how important is the credit score if one going in for a new credit card or a new loan? In other words, where does the fledgling borrower stand?
Credit Scores and History after opening a First Line of Credit
With an already Good Credit Score , availing a credit card or a loan wouldn’t be a hassle. But after getting the same, prudence must be observed in making payments and settling dues in a timely fashion, while maintaining the factors before getting an active line of credit.
With an active line of credit, one must ensure not to severely affect the utilisation ratio which is the gross outstanding amount divided by the gross credit available (O/C). Ideally, it should remain below 30%. So, if there are payments on a loan and a dues on credit cards, they would be matched up against all the credit available on any number of cards. Doing a simple division of all the payments against the total credit monthly will help in calculating the utilisation ratio.
It is imperative that more care be taken after opening an active line of credit, because expenditures could plummet owing to the increased spending capacity. It is advised to cut down on wants and live lean until a more favourable financial situation is achieved in terms of credit.
Credit Score and Information - The Accessible El Dorado
Credit scores, information and history calculated by CIBIL is based on information provided by the banks. These reports are available to other banks and even to individuals. For a new borrower, it is advisable to get a report from a CIC at least six months prior to opening a line of credit. In case any discrepancies are noticed, a first-time borrower can easily rectify the grey areas in the financial history by making payments and settling dues. That goes on to indicate how responsible the individual or entity is, pertaining to the credit score and information. Credit scores and history can be easily marred and hard to repair; being responsible with finances avoids any unnecessary complications regarding the credit history.