Credit score determines your creditworthiness and helps a lender to decide if you qualify for a loan or a credit card. Credit history of a borrower is fundamental in determining the credit score. As per CIBIL, credit score ranges from 300 to 900 and those with a score of at least 750 points, get faster loan approvals.
Credit score has a direct impact on your financial life. Higher credit score suggests lower risk of default and vice versa. Below are seven factors that can impact your credit score:
1. Don’t miss the due dates
Missing the due date of your credit card bill, not paying equated monthly instalments (EMIs) on time, has a negative impact on your credit history. Even if you have missed a single payment or EMI, it will be reflected in the report. The credit report shows the number of days for which the bill or EMI remained unpaid after the due date.
If your credit score is low because you don’t pay your bills on time, be prompt with your payments. Once you make it a habit, it will take at least 6 to 8 months for your credit history to improve.
However, good thing is that for now, besides loans or EMIs only credit card bills are considered while evaluating credit history and other household bills are not taken into consideration. Speaking about the Indian way of evaluating credit score, Radhika Binani, Chief Products Officer, Paisabazaar.com says, “Unlike many countries in the West, credit bureaus in India so far have not factored in payments of mobile and other utility bills for calculating credit score.”
2. Maintain a healthy credit utilisation ratio
Credit utilisation ratio can be defined as how much credit is availed from the given credit limit. It is calculated in percentage terms. For instance, if your credit card limit is Rs 1 lakh and you have utilised only Rs 40,000, then credit utilisation ratio will be 40%.
This ratio is calculated on the basis of total credit limit available on all the credit cards you have. Suppose if you have three credit cards having credit limit of Rs 50,000, Rs 1 lakh and Rs 1.5 lakh, respectively. The total credit used from three cards is of Rs 90,000. Then the credit utilisation ratio, in this case, will be 30% (90,000 divided by Rs 3 lakh).
Binani says, “Lenders and card issuers prefer loan applicants with credit utilisation ratio of less than 40% of the total limit.” Therefore, it is safe to say that lower the credit utilisation ratio, higher will be your credit worthiness. One can improve his credit utilisation ratio by regularly paying credit card bills and avoiding excess utilisation of credit limit.
Another important factor that borrowers need to consider is EMI-to-Income Ratio. It is calculated as your monthly loan and credit card repayments divided by your income. The rule of thumb says, maximum EMI-to-income ratio is 50%, as lenders assume that you will need half your salary for living expenses.
Explaining EMI-to-Income Ratio, Hrushikesh Mehta, VP and Head, Direct to consumer Interactive, TransUnion, CIBIL, says “If your monthly income is Rs 50,000 and your total current EMI outgo is of Rs 10,000, then your EMI-to-income ratio will be 20%.”
“If you apply for an additional loan, it will be sanctioned on the basis of your ability to carry additional EMI burden. The additional EMI a lender assumes you can repay is Rs 15,000 (50% of Rs 50,000 – Rs 10,000). Based on this, the loan amount will be sanctioned keeping current rates in mind. Also, the salary in this case is taken as take home salary and not the gross total income.” Mehta adds.
3. Don’t increase your credit card limit frequently
Although an enhanced limit on your credit card gives you the flexibility of availing more debt, this can affect your credit score if not used judiciously. Lenders try to gauge the net worth (assets minus liabilities) of an individual before sanctioning a loan. Frequent increase in the credit card limit could be seen as sign of being dependent on credit to manage expenses, something that raises a red flag for a lender.
4. Make sure all your old loans are ‘closed’ and not ‘settled’
Any default on old loans is reflected in the credit history. A default lowers your credit score and credit worthiness. If a default is reflected on your credit report, you must immediately settle it and ensure that ‘closed’ status is shown instead. You should also get a formal closure certificate from the lender.
Accepting a one-time or partial settlement can have a negative impact on your credit score. When you settle an account, it means that the bank is agreeing to accept a payoff amount that is less than the amount originally owed. Since the lending institution is taking a loss, a status of “settled” is reflected in the report. This might be considered potentially negative and detrimental to the chances of loan approval. Accepting such offers suggest your inability to repay. “Borrowers should avoid settlement as far as possible because these are reported to the bureaus, which further mark such accounts as ‘settled’ in their credit report,” says Binani.
Contrary to settled, ‘closed’ status of a loan account suggest that the loan has been fully paid off by the borrower and helps keep your credit score healthy.
5. Keep your credit report error free
You must check your credit report frequently throughout the year to ensure that it does not have any errors that may affect your credit score. A credit report may contain errors such as default on your payments or spelling mistake of your name.
Binani says, “Ideally, every individual should check his credit score regularly, once a quarter if not once a month, to stay updated and build it over time with responsible credit behaviour.”
If there’s an error, you can correct it online by logging in to the credit bureau’s website or by sending a duly filled dispute resolution form to the bureau.
6. Read your credit report first before applying for a loan
As mentioned above, credit score determines the credit risk. So, if you have a low credit score, a bank might charge you higher interest rate for the loan or even reject your application.
Binani says, “Correcting credit report may take up to 1 month or even more. If you are planning to apply for a loan, get your credit report at least two months in advance, so that you have time to make improvements in your score or correction, if required.”
7. Not having a credit history
This might come as a surprise to many people but not having a credit history has a negative impact on your credit score. Your credit score is determined on the basis of your loan repayment history, credit behaviour, credit utilisation limit along with other factors. If you do not have a credit card or have not taken a loan in the past, then it might make it difficult for the lender to determine whether you fall in the high risk or low risk category.
According to Mehta, “If you do not have a credit history or a credit card, then you will not have a credit score and will be considered as new to credit. As the score cannot be generated, in such cases, lenders look at other factors like income and employment to determine the repayment capacity.”
Having a good credit history strongly improves the chances of a loan approval. Moreover, as many lenders have started to consider credit scores while fixing interest rates, having a good credit score can help get cheaper loans.