People are increasingly becoming dependent on credit for a variety of reasons, such as buying or renovating their homes, going for a vacation, buying gadgets, and so on. Availing of loans actually smoothens cash flow during hard times. Hence, it is essential to know what your credit score is, how it is computed, the importance and, of course, ways and means to acquire and maintain good a credit rating.
Credit scoring and its mechanics
Availing of a credit means that one is borrowing money with a promise to pay it back within a specified period of time, with interest. Credit score is a statistical method to compute the possibility of a person paying back the money that he has borrowed. Credit bureaus, such as Credit Information Bureau-India (Cibil), issue these scores based on various parameters, such as current debt, credit type mix, credit utilisation, recent behaviour, time length, credit history and frequency of applications for new credit and, of course, repayment capability. The score assigned by Cibil ranges between 300 and 900. A score closer to 900 depicts the confidence in the ability of a person to repay the loan. A good credit score not only determines whether a person qualifies for the loan or not, but also increases the chances of availing of the loans faster.
Importance of credit score
When a person applies for a credit card or a housing loan, his credit score is checked. According to a person’s credit score, bankers will compute what risk he poses to them. From the lenders’ point of view, increased credit risk means that a risk premium must be added to the loan. If a person has a poor credit score, lenders will lend him money at a higher rate than someone who has a better credit score. The differential interest, owing to the poor credit score, will have a significant impact on the equated monthly instalment (EMI).
Ways and means to acquire a good credit score
Timely repayment of a loan and, also, the correct amount — paying less than what is due will negatively affect your credit score — is important. Don’t ignore the overdue bill. If you are facing difficulties in repayment, you should call the lender to make an arrangement. If you inform the lender about your problems, they are often flexible.
Be aware from whom and what type of loan you propose to avail. Generally, credit from non-banking finance companies carries higher interest rates and rigid terms and conditions. One must keep the outstanding debt as low as possible and avail of credit only when it is absolutely essential, keeping in mind the current and near-future cash cycles.
The writer in an associate professor of finance and accounting at IIM Shillong