Finschool By 5paisa

What are Credit Scores and How are they calculated?

What are Credit Scores and How are they calculated?

Creditworthiness, or the capacity to repay debt, is determined by a person’s credit score. It is commonly stated as a numerical value based on a person’s payback history and credit files from various loan kinds and credit organisations. A credit rating is another term for a credit score.

The Reserve Bank of India has licenced four credit information firms in India. Credit Information Bureau (India) Limited (CIBIL), Experian, Equifax, and Highmark are the companies in question. The CIBIL rating is the most widely used credit score in India. The CIBIL credit score is a three-digit figure that goes from 300 to 900, with the highest score being 900.

Credit Scores and How They Work

Your credit score has a huge impact on your financial situation. It has a big impact on whether or not a lender would provide you credit. People with credit ratings of less than 640, for example, are classified as subprime borrowers. In order to compensate themselves for taking on additional risk, lending institutions frequently charge higher interest rates on subprime mortgages than on standard mortgages. For borrowers with a poor credit score, they may also request a shorter payback period or a co-signer.

The quantity of an initial deposit necessary to receive a smartphone, cable service, or utilities, or to rent an apartment, may be determined by a person’s credit score. And lenders look at customers’ credit scores all the time, especially when choosing whether to adjust a credit card’s interest rate or credit limit.

 How is it Calculated?

A credit score is a three-digit figure between 300 and 900. It is computed by the country’s credit bureaus. Lenders such as banks and non-banking financing firms (NBFCs) often consider a score of 750 or more to be desirable. To calculate credit scores, each credit bureau has its own algorithm. Payment history, credit use, credit age, and credit type are all criteria taken into account while calculating it. Let’s take a closer look at each of these criteria to see how they affect your credit history and score.

1)High-Impact Payment History:

One of the most crucial elements that impacts your credit score is your payment history. If you have paid your bills/loan EMIs on time, it indicates that you are a responsible lender who is less likely to fail. Responsible credit behaviour will also qualify you for lower interest rates on loans and faster processing of your applications. Late payments, missed payments, and other infractions will drop your score by many points.

2) Credit Utilisation Ratio – High Impact: 

The second most important aspect that influences your credit score is your credit utilisation. The entire amount of credit you’ve utilised in relation to the total credit limit available to you is referred to as a credit utilisation ratio. The credit utilisation ratio is derived by dividing your entire credit limit by your total outstanding debt. Experts recommend that people utilise just 30-40% of their credit limit to keep a strong credit score.

3) Age of the Credit – Moderate Impact:

Your credit history is also taken into account while calculating your score in order to properly analyse your creditworthiness. Your credit score will improve if you have handled your credit responsibly in the past and continue to make payments on time on your active credit lines. A long credit history aids lenders in making an informed choice about whether or not to extend credit to you. As a result, it is recommended that you maintain credit cards with a lengthy history open rather than new cards.

4) Total Accounts – Low Impact: 

Maintaining a proper mix of secured and unsecured credit is critical. A credit card is an example of unsecured credit, whereas a vehicle loan or a home loan is an example of secured credit. A credit mix might help you improve your score. Although it has a lesser influence than other aspects, it should not be overlooked. Your total accounts represent your credit management experience with both forms of credit. You should avoid taking out a lot of one sort of credit since it will hurt your credit score.

Your credit inquiries (hard inquiries), in addition to the types of accounts, are taken into account when determining your score.

Advantages of Having a Good Credit score
  1. Obtain Quick Loan Approvals

Before providing you a loan, every financial institution will verify your credit score. The lender will consider you a low-risk consumer if your CIBIL score is good. This increases your chances of getting a loan.

  1. Get a Loan with Attractive Interest Rates

If you have a high credit score, say above 800, the lender may opt to provide you favourable loan terms. A strong credit score puts you in good standing with financial organisations. You’ll be able to haggle the available prices and acquire a decent deal this way.

  1. Obtain Credit Card Access

Before issuing you a credit card, most financial organisations will verify your credit score. So, if your score is above average, acquiring a card will not be difficult. That’s because your credit history will reflect all of your timely payments on your credit card or loan. Customers that pay their bills on time are preferred by banks.

Checking your Credit score periodically to see if you need to work on your score is very important to boost your Credit score.



Related Articles