A witty joke about credit scores goes something like this - “I'm confused as to why my credit score is so low...My bank says I have an ‘Outstanding’ balance on my card!”
While this is certainly a joke, your credit score is no laughing matter. Experts give us the ins and out of the credit score game and why you, the consumer, must be very careful of your numbers (credit score of course).
“A drop in your credit score can negatively impact your overall financial health, making it more difficult to achieve financial goals or prepare for unexpected expenses,” cautions Manavjeet Singh, MD & CEO, CLXNS Technologies.
This down-rating may also result in higher interest rates on loans and credit cards, lower credit limits, and even loan or credit application rejections.
Conversely, a rise in your credit score can have a positive impact on your financial well-being, helping to improve your overall creditworthiness and providing more flexibility in managing your finances. This can lead to more favourable terms and lower interest rates, making it easier to obtain credit.
“Consumer credit scores are one of the most significant factors lenders consider when granting credit,” explains Saikrishnan Srinivasan, MD, Experian Credit Information Company of India, talking about why our credit score is important in interaction with financial institutions.
Lending institutions evaluate one’s credit history and repayment behaviour before approving a loan.
A higher credit score signifies lower default risk, making him/her an attractive borrower. This brings several benefits, including low interest rates and flexible loan terms. The availability of different types of credit, including short-term loans like BNPL, becomes easier.
However, the flip side also holds true. A lower credit score can make credit access difficult. It can lead to higher interest rates and fewer credit options.
The credit score can be improved by making timely payments, checking credit reports regularly for errors and reporting discrepancies in real-time, maintaining a low credit utilisation ratio and among others.
Jugal Mantri – Executive Director and CEO, Anand Rathi Global Finance, gives us an insight into how CIBIL score is generated.
First is your credit history which carries the most weight. So, 30 percent of your CIBIL score is affected due to delay in payments.
Next is the credit mix and duration. Too many loans and credit cards affect about 25 percent of your CIBIL score.
After that is your credit exposure. In this factor, 25 percent is when the credit limit is increased.
Finally are other factors: 20 percent is attributed to them.
We must know even more how our spending habits and financial decisions affect our credit score.
“People often overlook actions that affect your score, even if you were doing something you thought was positive,” says Tejinder Singh, Senior Consultant, Alpha Capital.
Thus, card issuers pull your credit report when you apply for a new credit card because they want to see how much of a risk you pose before lending you a line of credit. This credit check is called a hard inquiry, or “hard pull,” and temporarily lowers your credit score a few points. Hard inquiries remain on your credit report for two years, but FICO (which most lenders use) only considers inquiries from the last 12 months when calculating your credit score.
Credit cards are convenient for making large purchases because you don’t need to pay all the money upfront, but leaving a high balance on your card will report a higher credit utilization rate (CUR) to the credit bureaus.
Your utilization rate, or your debt-to-credit ratio, measures how much credit you use compared to much you have available. You want to aim for a low utilization rate because using too much of your available credit limit shows that you pose a financial risk to issuers.
Experts recommend keeping your credit utilization below 30%, with some even suggesting below 10% getting the best credit score.
Because your payment history is the most important factor that determines your credit score (making up 35% of your FICO score calculation), missing a credit card payment will have an immediate negative effect on your score. Needless to say, lenders and issuers care a lot about whether you’ve paid your past credit accounts on time because they indicate your risk.
While paying off your credit card debt can increase your credit score, paying off installment debt, such as a mortgage or a student loan, has the opposite effect.
Paying off something like your car loan can actually cause your credit score to fall because it means having one less credit account in your name. Closing a credit card account, especially your oldest one, hurts your credit score because it lowers the overall credit limit available to you (remember you want a high limit) and it brings down the overall average age of your accounts.
“A 10- or 20-point drop in your credit score may not make a big difference when it comes to your ability to borrow money or qualify for a new credit card. But a 100-point drop could spell the difference between getting approved for a loan or credit card, or getting rejected,” says Singh of Alpha Capital.
Imagine you're interested in a great credit card offer. If that offer is reserved for applicants with high credit scores and yours goes from a 750 to a 650, you may be denied.
Furthermore, you'll need a minimum credit score of 620 to qualify for a conventional mortgage. If you have a score of 700 but that number then plunges by 100, you'll be below that threshold. A 100-point drop in your credit score could also mean getting stuck with a higher interest rate on a mortgage, making that loan more expensive.
Credit score algorithms treat lower- and higher-risk consumers differently, even for the same negative credit event. In the case of a late payment (a relatively minor negative event), a high credit score suffers a more drastic drop than a low credit score. “On the surface, this seems counterintuitive, but this is because the individual with the higher credit score presents the lower credit risk to lenders,” explains Singh of Alpha Capital.
So it is very important to keep your credit score positive. Experts give us good advice how you can be in the good books of the credit score providers.
“Regularly monitoring your credit report is crucial to identify and address inaccuracies in a timely manner,” says Srinivasan. Report any inaccuracies to credit bureaus and request corrections to maintain a healthy credit score.
Ensure timely payments of credit card balances and loan installments, as consistently meeting payment deadlines demonstrates responsible financial behaviour and positively impacts your credit score.
Maintain older credit accounts, as they demonstrate stability and contribute positively to your credit score.
Aim to reduce credit utilisation by keeping your credit card utilisation low compared to the available credit limit. High credit utilisation can have a negative effect on your score, so strive to pay off existing debts and avoid maxing out your credit cards.
It is important to limit new credit applications which can temporarily lower your score. Apply for credit only when necessary and consider spacing out applications to minimise potential impacts.
“Additionally, building a long credit history establishes a track record of responsible credit management,” says Srinivasan.
“To improve your credit score, you should focus on paying bills on time and in full, reducing credit card balances, limiting new credit inquiries, keeping old credit accounts open, and monitoring credit reports for errors. It's important to address any negative items on your credit report, such as late payments or collections, and work to improve your overall credit history,” says Singh of CLXNS Technologies.
Another strategy for improving your credit score is to diversify the types of credit accounts you have, such as having a mix of credit cards, installment loans, and mortgages.
Also, it's important to be patient and consistent in your credit-building efforts, as it can take time to see significant improvements in your credit score.
“In just a few hours, you can set due-date alerts for bills, so you know when a bill is coming up. Paying your bills on time is one of the most important steps in improving your credit score,” advise experts.
As a sidebar, it's important to be aware of your rights as a consumer under the Fair Credit Reporting Act and to dispute any errors on your credit report promptly.
“Improving your credit score is a long-term process that requires discipline and patience. There is no quick fix to improving credit scores, but by following sound credit management practices and monitoring your credit reports regularly, you can improve your creditworthiness over time,” says Singh of CLXNS Technologies.
Negotiating with your bank
Experts advise us on how to negotiate with the financial institutions that our financial overhang is not very affected or limited.
“An applicant may approach the institute with the valid reasons along with the supporting documents which would help the institute in analyzing and understanding the reason for drop in your credit score and if they are satisfied they may relax or waive you from severe interest rates,” says Mantri.
There is an insight over here and this is a good relationship with your lender.
When a borrower takes a loan from an institute and makes timely payment of EMIs, a new relationship has been established between them.
“It's also important to be realistic about what you can afford to pay, as negotiating for lower payments that are not sustainable in the long run may end up harming your credit even more,” cautions Singh, CLXNS Technologies.
“Arranging for a reduced interest rate is one of the most common requests consumers make to credit card issuers,” says Singh of Alpha Capital. In many cases, securing a lower rate is as simple as contacting the card issuer and asking for it. If you have an established track record of making on-time payments, you have a good chance of success.
If you’re temporarily unable to make even your minimum payments, you may have alternatives to a loan default, which can create a blemish on your credit reports that lingers for years. Among the options are two types of repayment plans: forbearance agreements and long-term repayment plans.
Manik Kumar Malakar is a personal finance writer.