What Is A Credit Score And How It Works (2024)

India’s evolving retail credit landscape is giving rise to a new financially-literate and digitally-savvy population. This cohort of customers are moving away from the conventional tedious cycle of availing loan products, to now opting for quick financing options available to them at the click of a button on their computers or mobile.

Credit financing instruments such as credit cards or products like small-ticket loans as well as longer-term loans now being available digitally are becoming popular among this set of new-age customers, thereby augmenting the rise and popularity of retail credit demand in India. In order to access and be eligible to such credit offerings, an individual borrower must fulfill some financial prerequisites that make accessing credit channels seamless.

A “credit score” plays a crucial role in determining the overall eligibility of a borrower when applying for a loan. However, in order to ensure that the loan or credit product is sanctioned by lenders, it is a prerequisite to have complete and credible knowledge about financial health and creditworthiness that would not only shape the borrower’s credit application but also his/her future financial credit needs.

What is a Credit Score?

A credit score is a metric that determines an individual’s credibility to return debt or loans based on their credit history and financial well-being. This three-digit number or metric denotes the eligibility and goodwill of an individual for a lender, be it a bank or a non-banking financial corporation (NBFC).

A good credit score ranges anywhere between 700 to 900, highlighting that the borrower has a favorable and higher chance of obtaining credit from lenders.

To mitigate the risk of repayment defaults, traditional and new-age lenders, mortgage companies, credit card companies, etc. actively check the borrower’s credit score history before deciding the amount of credit to be lent and the appropriate rate of interest to be levied, which varies from borrower to borrower.

A higher credit score (750 to 900) indicates that a borrower is less likely to falter on credit obligations, whereas, in the case of a low credit score (300 or less), the risk and vulnerability of lending money is on the higher side.

Currently, four credit bureaus in India track and provide credit scores to individuals and businesses, namely – TransUnion CIBIL, also known as theCredit Information Bureau of India Limited, Equifax, HighMark and Experian.

The above-mentioned credit bureaus generate credit scores by analyzing several criteria such as the applicant’s repayment history, loan tenures, current outstanding debts, credit mix, the ratio of debt to income, frequency of request to raise fresh credit, etc.

Therefore, it is pivotal to be aware of how to manage credit commitments to develop and maintain a positive credit history that has a direct bearing on an individual’s credit score. The CIBIL report is the most preferred choice among the lenders to determine their decision to extend credit facilities to borrowers.

Credit Score Vs. CIBIL Score

Credit score and CIBIL score are two similar terms which are often used interchangeably, when initiating the process of availing credit facilities with any lender. In simple words, a credit score defines a borrower’s creditworthiness that is generated by credit bureau organizations.

On the other hand, CIBIL stands for Credit Information Bureau India Limited (CIBIL), which is one of the leading credit bureaus in India. The bureau collects credit-related information from banks and financial institutions, which also includes NBFCs and Digital Lenders to create and generate credit reports and credit scores for individuals. The credit score and report are shared with the lending institutions, as well as individuals can also have access to view them.

CIBIL credit score is derived and published in the CIBIL credit report, a statement that has the necessary information about any past or current consumer’s credit activity and reflects their current credit standing. The report considers the borrower’s profiles over the last 36 months, which include all types of loan the applicant has taken, including auto loans, overdraft facilities, home loans, credit cards, consumer durable loans, personal loans, etc.

In this dynamic and digital ecosystem where financial data and behavior is captured on a real-time basis, borrowers need to understand the impact CIBIL scores can have on their ability to seek credit products and to avail favorable loan servicing terms from a lending institution.

What is a Good and an Average Credit Score?

A credit score of 500-600 is generally considered average, rating of 600-700 is considered good, rating of 700-800 is considered very good , and rating of 800-900 is considered excellent and can empower the borrowers to work the terms and conditions in his or her favor.

Ratings below 500 reflects the poor capability of a borrower to repay the loan amount and lower the chances of availing credit facilities.

Borrowers should have a good credit score for a variety of reasons.

1. Reflects financial stability: A healthy credit score reflects positively on the borrower’s overall financial commitments and actions. The credit score is unbiased and is evaluated on the basis of the borrower’s past and current financial transactions towards credit products.
2. Quality credit and loan deals: A favorable credit score indicates that the borrowers are credible, hence lenders would onboard them as their customers. Therefore, a good credit score can help the borrowers to seek some attractive deals and offers on their future credit requirements along with relatively faster approvals on loan application and disbursal, attractive interest rates and longer loan terms.
3. Qualify for higher limits: Customers with impressive credit scores are often offered a higher credit limit based on the fact that they have earned that credibility for being a diligent and disciplined borrower.
4. Allows better negotiation terms: Every lender wants borrowers who are less likely to default on their payments. With a higher credit score, a borrower can engage with the lender to give them flexibility in enjoying special deals in availing competitive interest rates, long loan tenure and no extra charges for prepayment of loan.

What is a Credit Score Comprised Of?

A credit score which is generated by the credit bureaus is an amalgamation of many parameters based on the borrower’s financial history. Here are some factors that contribute towards developing a good credit score:

1. Repayment history: Considered to be the most significant factor, the repayment history accounts for 35% of weightage in the credit report. It assesses whether timely payment of bills or EMIs have been paid in the past. Delayed payments or EMI defaults can damage the credit score drastically.
2. Credit Utilization: This is a representation of the amount of credit being used in comparison to the total credit available to the customer. Its weightage in the credit report in terms of influencing the lender’s decision-making is 30%. Hence, it is critical to maintain and use a smaller percentage of available credit.
3. Timeline of credit history: 15% weightage is given to this particular factor, thus making it the third-most influential category as it considers the vintage of the credit account. A longer credit history can demonstrate the ability to manage credit over time, which in turn can be of immense value to increasing the credit score. In terms of irregularity in payments, customers need to plan better to avoid such a situation as it will only hamper their respective credit scores.
4. Credit mix: Lenders typically prefer to see and evaluate a mix of different types of credit products, such as credit cards, installment loans, mortgage loans, finance company accounts and retail accounts. Having a diverse credit portfolio and managing it robustly can contribute positively to an individual’s credit score. This category makes up 10% of the credit score. Also, instead of opening several accounts at once, it is ideal to spread out new credit applications while avoiding taking on new debt for the sole purpose of improving credit mix.
5. New credit applications: Another 10% of the score comes from this category. One of the key aspects considered is how many recent inquiries or credit checks show up in the report. Therefore, instead of applying for a loan with many lenders at any given time, research the best lenders and only apply for a loan with a select few to avoid multiple credit enquiries. Such hastening indicates desperation on the borrower’s end which might result in harming his/her credit score.
6. Public Records: Negative public records, such as bankruptcies, tax liens, or civil judgments, can significantly impact the credit score too. These records indicate financial troubles and are viewed unfavorably by lenders.

How to Report Discrepancies and Frauds in a Credit Report

Periodic reviewing of one’s credit report is essential. In case of any errors or discrepancies in the report, a borrower should take the immediate step to report the incorrect data to the respective credit bureau and seek remedies for rectification.

The redressal can be initiated by filing for dispute resolution on the credit bureau’s website and following the guidelines mentioned for the same. If the dispute is accepted, corrections will be reflected in the revised report, however the time taken for the correction (usually 30 to 45 days) would depend upon the extent of discrepancies.

If consumers are not satisfied with the resolution given by the credit bureau, another dispute can be filed. Attaching relevant supporting documents, if any, while reporting the discrepancy is recommended.

The borrower should also inform the lending institution concurrently about such discrepancies.

Bottom Line

A credit score acts like a mirror and benchmark for both the borrower as well as the lender to understand the credit consumption and behavior of the borrower and helps in offering a suitable credit facility, which does not burden both the parties. A credit score is something that is built gradually and can be improved steadily. Regular monitoring of credit scores is important to be in complete control of one’s credit performance and to enjoy the perks of being a diligent borrower for future financing needs.