What is a Credit Score and Why it is so Important?

What is a Credit Score and Why it is so Important?

Do you know your loan application can be rejected even if on paper you are a sound applicant? The main reason for such rejection can be a poor credit score. Among the factors like the salary of the applicant and repayment capacity, the credit score of the applicant is the topmost thing that lenders check out. A person with a higher credit score is preferred by the lenders while a person with a lower credit score may be passed for the loan application. But the important thing to understand here is the meaning and importance of a good credit score. 

Given below is the meaning and the term credit score and the importance of a good credit score along with a few related details.  

What is a credit score?

A credit score is a rating of the creditworthiness of a person and businesses. It is a three-digit score ranging between 300 to 900 and is issued by certified credit rating agencies. These agencies include CIBIL™, Experian, Equifax, and CRIF High Mark. This number is issued based on various factors like the credit history of the person or the business, the ratio of their credit utilization, the ratio of their credit mix, etc. A higher score is preferred by the lenders when considering a loan application and most lenders consider 750 and above to be a good credit score. A credit score in the range of 600 or lower is considered to be bad and risky by lenders and applications with such credit scores are rejected unless backed by strong security or collateral. 

Why is a good credit score important?

Having a good credit score opens many doors and opportunities for individuals. The importance of having a good credit score is explained in the following points. 

  1. Faster loan approval

As mentioned above, the credit score of the applicant is among the top five things reviewed by the lenders. An applicant having a higher credit score is considered to be a safe bet as the lenders are assured of the creditworthiness of the applicant and the viability of the loan given. Therefore, this results in lesser documentation and a hassle-free faster loan approval process. 

  1. Better interest rates

Having a good credit score helps in getting loans at better interest rates. A person with a good interest rate will be eligible for a loan at a comparatively lower interest rate as compared to a person having a poor credit score. The applicant with a good credit score will have a better negotiating power to have better terms of the loan application, for example, in the form of longer tenure, competitive interest rate, etc. 

  1. Higher loan amount

The loan amount sanctioned by the lender is dependent on many factors like the repayment capacity of the applicant, any existing liabilities, etc. When an applicant has a higher credit score, they may be eligible for a higher loan amount than that they have applied for. 

  1. Higher credit card limit

The credit limit of a person is directly dependent on their credit score. A higher credit score will help in getting a higher credit limit as compared to a person with an overall same profile but a lower credit score. Another benefit of having a higher credit score is getting credit cards at a lower interest rate. 

  1. Better chances of approval in visa application 

When a person applies for a visa for countries like the UK, the USA, and others, the review committees of the visa application may also check the credit score of the applicants. The income tax records of the applicant are also reviewed and filing regular income tax returns can be seen as a positive sign for the credit score of a person.

  1. Access to pre-approved loans

Most banks and NBFCs offer pre-approved loans to their customers and potential borrowers. The concept of pre-approved loans is based on a good credit score apart from other key factors that assure the lender of the viability of their loan. The pre-approved loan is also beneficial for the potential borrowers as they can get access to funds immediately and through a hassle-free process.  

How to improve your credit score?

Now that we have understood the importance of having a good credit score, let us not discuss the various ways that a person can boost their credit score so they can enjoy the benefits of the same. 

  1. Paying dues on time 

The first and foremost step in building a good credit score is paying all the dues (EMIs and credit card dues) on time. It accounts for almost 35% of the weightage in the calculation of credit score. Such regular payment will assure the lenders of the creditworthiness and the sound repaying capacity of the person.

  1. Lower credit utilization ratio

The term credit utilization ratio refers to the ratio between the amount of credit available and the credit actually utilized in a credit cycle. Most experts believe that the ideal credit utilization ratio should be a maximum of 30%. It is not wise to utilize 100% of the credit limit. Such excess credit utilization sends the message that the applicant is not financially sound enough to manage daily expenses without credit availability.  

  1. Timely payment of utilities

A majority of people today pay the utilities online either through UPI or credit cards. The timely payment of utilities is another factor that boosts the credit score of a person as it shows that such person is financially sound to meet all the regular obligations. Paying the utilities through credit cards also allows the cardholder to enjoy a free credit period of approximately 50 days.

  1. Balance between secured and unsecured loans

Another important tip to have a good credit score is to have a balance between secured and unsecured loans. A person having more unsecured loans may be considered to be riskier as compared to a person having more secured loans. A correct balance between the two will give the applicant a chance to improve their credit score by showing regular repayment of both types of loans.

  1. Managing the credit applications 

When a person applies for multiple loans and credit card applications at the same time, it sends a wrong message to the lending agencies. When such applications are received by the lending agencies, they make a formal inquiry about the credit score of the applicant. Such frequent credit inquiry shows that the applicant is eager to get credit in any form and this may damage their credit score. 

  1. Avoid payment of the minimum balance due only 

The benefit of having a credit card is getting the free credit period for all the expenses. At the end of the credit cycle, cardholders have to clear their balance to have a fresh credit cycle and also avoid the high-interest charges on their outstanding amount. However, in case the cardholder is not able to pay the full amount of credit card dues they can pay the minimum amount due to renew their credit cycle. This should be a one-off occasion and not a frequent habit as consistently paying only the minimum amount due from the credit card bill is a big red flag. It severely damages the credit score and may also blacklist the 

  1. Having a lengthy credit history

Nowadays, most banks and credit card companies offer free credit cards to their customers and they end up having multiple credit cards which may only add to their expenses. Following this, the cardholders may want to close a few credit cards and reduce their overall expenses. The key factor to remember in this case is to close the newer credit lines and maintain the older credit history as they can add weightage to the credit score and improve it.

How is a credit score computed

A credit score reflects creditworthiness, calculated using factors like payment history, credit utilization, length of credit history, types of credit accounts, and recent credit activity.

• Payment history: Timely payment, no missed or late payments. • Credit utilization: Amount of credit used compared to total available. • Length of credit history: Time duration of credit usage and number of accounts. • Types of credit accounts: Mix of different credit accounts can be beneficial. • Recent credit activity: Opening new accounts or applying for credit can impact score.

Improving credit behavior can lead to better scores, helping individuals obtain credit, secure lower interest rates, and achieve financial goals.

Conclusion

A credit score is a very important aspect in today’s world but is still often ignored or is not hugely popular among the general public. Having a good credit score improves the chances of getting timely financial help from any bank or NBFC. At the same time, a good credit score improves the negotiating power of the customer while availing of such loans. 

FAQs

How is credit score calculated?

A credit score is calculated based on many factors that are unique to every credit rating agency. However, the broad factors considered by them and their weightage are given below.
-Payment history – 35%
-Credit utilization – 30%
-Credit history period – 15%
-New credits taken – 10%
-The credit mix of the applicant – 10%

Can credit inquiry by self have an adverse impact on the credit score?

No. credit score inquiries made by self are considered to be soft inquiries and do not have an Want to learn about Finance, Investing, and much more!, Checkout our partner blogs.