What is Credit score and why it matters?

Well, what is Credit Score? Imagine a person goes to the bank and applies for a loan or a credit card. Does the bank approve the loan/credit card directly, without any background check? The clear answer is, no. Why? Because the banks are businesses. They are siting there to make profits, not to do charity. Whenever someone applies for loan with a bank, the first thing the bank thinks is to determine how risky is it to give the loan to that person. If they think the person is ‘worthy’ of the loan or credit, then only they will proceed ahead with his application.

So, the question is, how does a bank determine whether a person is ‘credit worthy‘ or not? They check the complete details of that person’s finances: Existing loans, Credit cards, how much credit is used by them on an average etc. If the person has availed loans/Credit cards in the past from any other bank or financial institution, has he repaid the instalments/bills regularly on time or not?

It short, the first thing any bank checks for proceeding ahead with your application is your history of dealing with credits.

Your credit score gives a summary of your credit worthiness. Whenever you apply for a credit, the bank checks your credit score. If you have a good score, banks proceed ahead with your application. If you have a poor credit score, banks might reject your application, since your poor credit score reflects that you are not able to manage your credits in a good way.

Lets see the factors which affect your credit score:

1. Repayment history (Impact: High): It is the most important factor for determining your credit score and it shows whether you pay your bills and EMIs on time or not. Better repayment history you have, better your credit score is.

2. Credit utilization ratio (Impact: High): It comprises of the amount of credit you avail out of the total credit allotted to you by your bank. If your credit limit is Rs 1L and you are using Rs 20k credit, then your Credit utilization ratio is 20%. Keeping a Credit utilization ratio less than 30% is advisable.

3. Credit type (Impact: Medium): It means whether your credit type is secured or not. The more secured credits you have better your score will be. Generally, loans are secure Credits and Credit Cards are unsecured credit type. However, personal loan is unsecured and Credit cards issued against Fixed deposits are secured.

4. Other factors like number of credit instruments, age, number of enquiries etc (Impact: Low): Older your credit cards/loans are, more they better your credit score will be. Also, if you keep enquiring your credit scores again and again, it might have a negative impact on your credit score.

Lets see some advantages of having a high credit score:

1. Cheaper interest rates: Higher credit score means better chances for the bank to get their money back(with an interest). So, banks might offer you a better interest rate on loans.

2. Quick approval for loans/credit cards: If your credit score is good, the banks get a trust with your capability of handling credits and sometimes even provide relaxation/fast track on the approval process

3. Access to better/premium credit instruments: With consistently good credit score, you get access to credit cards with better rewards and benefits.

4. Higher Credit card limits.

5. Pre-approved loans: If your credit score is good, you get access to pre-approved loans. Which means you can get the money in your bank account within minutes in case of an emergency.

Some important facts about Credit Score:

1. Salary/Income does not impact your credit score.

2. Applying for new credit cards in a short time can impact your credit score. This is because every time you apply for a loan or a credit card, the bank does a hard enquiry for your credit score, and this impacts your score a little.

3. Keeping high balance in your bank account does not improve your credit score.

4. Debit cards do not impact your credit score.

5. If you don’t use credit cards at all, your score won’t increase. Credit score can increase only when you are regular on using the credit and regular in paying off your credit.

6. Closing an old credit card will impact your credit score: Firstly, if the credit card is old, closing it will decrease the average age of your credits, which is negative. Secondly, if you close a credit card, the total limit of all your credits is decreased which results in increase of the utilization ratio, and thus a negative impact on your credit score.

Credit score is an important factor for keeping your finances in check. You should monitor your credit score regularly and keep an eye on the factors which are impacting your credit score and work towards improving your score.

Some good practices for keeping your credit score in a good shape:

1. ALWAYS pay your Credit cards and EMIs on time.

2. Keep your credit utilization ratio below 30%. If your credit utilization ratio is higher, contact your bank and get your limit increased.

3. Check your credit score regularly and take actions, if required.

4. Don’t apply for too many credit cards/loans in a short span of time.

5. Don’t close old credit cards unless you are paying significant annual fees/other charges on the card.

In 2017, the Reserve Bank of India (RBI) made it mandatory for all the Credit rating agencies to provide 1 free credit report per year. You can visit the following to get your free CIBIL score.

Have any questions related to the article? Let me know in the comments below. If you have any feedback or need any help in any topics related to finance, you can contact me using the Contact me section of this website.

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